What it means
In a long position, you buy an asset and gain if its price rises. In a short position, you borrow an asset, sell it, and gain if its price falls, because you can buy it back more cheaply later.
A zero-investment portfolio holds both, sized so the cash from shorting covers the cost of the long side. This means the portfolio's value at the start is zero, and every dollar of result is a gain or loss on the spread between the two sides.
Researchers use such portfolios to test whether a feature of stocks, such as being cheap or being small, is rewarded. A well-known approach is to buy the top group of shares on some measure and sell short the bottom group.
In practice, the portfolio is not really free. Short selling requires a margin account and collateral, so the investor needs capital to support the positions, and there are borrowing fees for the shares sold short.
The investor also earns interest on the cash from the short sale, which partly offsets those costs. Hedge funds use the idea to build market-neutral strategies, which aim to make money whether markets rise or fall.
If both sides move together with the market, the market effect cancels out. What is left is the manager's skill in picking the right stocks to buy and sell.
The nuance is that a zero-investment portfolio is not zero risk. If the shares you hold fall while the shares you sold short rise, you lose on both sides.
Losses on short positions are also theoretically unlimited, so risk limits and stop rules are essential. For a finance team, the idea is worth knowing even if it never trades one.
Performance reports often describe a fund as dollar neutral or market neutral, and the zero-investment view explains what that claim does and does not mean. It also shows why such a fund should be judged against cash returns rather than against a stock index.
In practice
Real-world examples.
Example
An academic builds a portfolio that buys the cheapest 20% of shares and shorts the most expensive 20%. The resulting return series shows whether cheap shares have beaten expensive shares over the decades. She publishes the results in a paper.
Example
A hedge fund runs a long-short equity strategy that is sized to be roughly dollar neutral. It earns a fee for stock selection rather than for market exposure. Investors use it to diversify a portfolio that is already heavy in shares.
Example
A bank trader sets up a pairs trade, buying one bank's shares and shorting a similar bank's shares in equal amounts. He expects the gap in their valuations to close. If both fall together, he loses little, because the two positions offset. He reviews the trade each week and closes it once the gap narrows to his target.
Formula
Calculation
Net investment = Value of long positions - Proceeds from short positions = 0
Portfolio return in dollars = Gain on long positions - Loss (or plus gain) on short positions
An investor buys $500,000 of shares and sells short $500,000 of other shares, so net investment is 500,000 - 500,000 = $0. Over the year, the long shares return 8%, a gain of 500,000 x 0.08 = $40,000. The shorted shares return 5%, so the cost of covering the short is 500,000 x 0.05 = $25,000. The net profit is 40,000 - 25,000 = $15,000, before borrowing fees and trading costs.Case study
Seen in the real world.
Stonebridge Partners is an illustrative, fictional hedge fund that manages $100,000,000. The portfolio manager builds a zero-investment portfolio by buying $40,000,000 of shares in companies with improving earnings and shorting $40,000,000 of shares with weakening earnings. She keeps the balance in cash as collateral.
Over a year, the longs return 10% and the shorts return 4%. The profit is 40,000,000 x 0.10 - 40,000,000 x 0.04 = 4,000,000 - 1,600,000 = $2,400,000. Borrowing fees and costs take $400,000, so the net gain is $2,000,000, which is 2% of the fund.
In the illustrative result, the stock market itself rose 15%, but Stonebridge's return was unrelated to that. The lesson is that a zero-investment structure earns the spread between winners and losers, not the direction of the market. Stonebridge's investors paid fees on the basis of that spread, and the fund reported its results against a cash benchmark rather than against the share index.
Watch out
Common mistakes.
- Believing it needs no capital, when margin and collateral requirements mean real money must support the positions.
- Assuming it is riskless, when the longs can fall while the shorts rise.
- Forgetting borrowing fees and trading costs, when they can remove much of the profit.
Questions
People also ask.
Why is it called zero-investment?
Because the cash raised from short sales pays for the long purchases, so the net amount invested at the start is zero.
Is it the same as market neutral?
Not exactly, since dollar neutral means equal amounts long and short, while market neutral means equal market risk on both sides.
Who uses these portfolios?
Academic researchers testing investment factors and hedge funds running long-short strategies.
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