Relaxing the Long-Only Constraint in U.S. Equity Strategies

Abstract

This article analyzes the factors that should be considered when seeking to relax the long-only constraint in equity portfolios. Traditionally, analysts have focused on the interaction among tracking error, transfer coefficient, information ratio, and risk tolerance. This article points out that the potential benefits of relaxing the long-only constraint will not be realized in practice if the short side of the portfolio is not managed appropriately. It also demonstrates that varying liquidity levels across different groups of stocks and the capitalization distribution associated with choice of benchmark can reduce or even negate the benefits of relaxing the long-only constraint if shorting is mishandled. These points are illustrated by comparing simulated portfolios benchmarked to the S&P 500, Russell 1000®, Russell 2500®, and Russell 2000® indices.