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Specialised short positions challenge beta behaviour

Long/short funds with specialised short positions have greater beta convexity and present greater liquidity strain in rebalancing, according to new research by Morgan Stanley.

The research, by Martin Leibowitz and Anthony Bova, which extends earlier work on beta convexity in long-only funds, looks at the beta convexity, or how a portfolio’s beta changes with equity market movements, in long/short funds.

It concludes that the type of short position taken by a long/short fund will affect the beta convexity, and that there are certain types of long/short funds that can have large beta variances and fundamentally different beta response patterns.

In normal markets, typical long/short funds, or those with the more common short position described as “short a long” position, exhibit beta behaviour similar to long-only funds having comparable beta values.

But the research shows portfolios with certain specialised short positions that are more like “long a short” where a declining equity market generates both higher profits and higher levels of short exposures, will have larger beta variances. They will also have highly variable betas, and may require large liquidity reserves for rebalancing purposes.

“Their beta response would be beneficial in trending markets, but they could generate significant portfolio losses in reversal-intensive markets,” the research says.

It also points out that it is “often unappreciated that a ‘rebalancing reserve’ of some size is needed to maintain beta value in declining markets”.

For example after a 30 per cent equity decline, a 60/40 fund would need to purchase 7 per cent of equity to rebalance to its original 0.6 beta. Funds with higher beta variance would need higher rebalancing reserves, the research says.

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