Equity Management #10 : Example on how a market neutral portfolio is constructed.

This is for the benefit of some readers who want more information on market neutral portfolios.

Right now, I still have no idea how a retail investor can get started on this form of investing and would be really grateful if intermediate investors can give me some tips on which brokers can provide this service. My only guess is that if you are high net worth, you might be able to talk to your private banker to start doing this.

The book mentioned that the portfolio manager hires the services of a prime broker who can also act as a custodian of the stock ( No CDP involvement in such a case ).

Procedure

In this example, the investor begins with $10 Million. He sets aside $1 million as a liquidity buffer in case his short positions turn against him, so he gets to trade $9 million of stocks.

1. Investor buys or goes long on  $9 million of stocks. These stocks are held with the prime broker that also acts as a custodian (CDP).

2. Investor shorts or sells $9 million of stocks at the same time. These are stocks which are not owned by the investor so needs to be borrowed by securities lenders.

3. When the stocks are being sold short, the broker needs to put up $9 million in proceeds to securities lenders as collateral for shares borrowed. If the shorted counters increase in value, the manager is expected to top up to allow the broker to maintain the collateral, which explains why he holds a $1 million in reserve.

How to make (or lose) money

If you have this arrangement, there are 4 ways to make (or lose) money :

1. Stocks you buy increase in value and pays out dividends.

2. Stocks you sell decrease in value. But you have to pay out dividends of stocks you short.

3. The $9 million of collateral posted to securities lenders generates interest which goes to the security lenders, broker and the investor. Unfortunately, the book mentions that this is subject to negotiation between the different parties so we get no clear idea as to how much money is earned here.

4. The interest rate from the $1 million spare buffer.

Arrangement your investments in this manner gives you the opportunity to earn or lose money in an a rising or falling market and everything boils down to your stock picking skills. In this example, I have not employed any derivatives or CFDs to create the long-short portfolio.

Hope that a kind Samaritan can share with us what needs to be done to have such an arrangement with a local broker as well as their personal experience combining longs and shorts in their investment strategy.