An Index is a pool of securities, weighted by their marketcap or stock price. It is used to measure the performance of other securities or stocks in the market. Dow Jones Industrial Average, Standard & Poors (S&P500), Russell 200 are examples of Benchmark Indices.
For Example: If there are 50 stocks in a benchmark portfolio, each stock's weighting in the portfolio can be determined by the relative sizes of their market capitalization. This will be a market cap weighted index (like S&P500 is).
When an investor (or trader) says they want to beat the benchmark, what they really mean is that they want to make more returns by picking stocks themselves than through investing in the exact composition of a benchmark index.
When an investor has no particular view of the market, they'd invest in the benchmark portfolio. But, when an investor has a view that is different to the benchmark, they change the weighting of the stocks in the benchmark portfolio i.e. they deviate from the benchmark index. Their view can now result in higher or lower returns relative to the benchmark.
Some investors say that they are Long Only - meaning - they do not short the securities they hold in their trading strategy. However, the fact that they are picking some of the stocks in the benchmark to hold and changing the weights per their view to maximize potential returns basically means they are implicitly shorting the stocks they are NOT picking from the benchmark. So, the stocks that investors pick to hold are important but at the same time the stocks that they do not pick are also equally important because that tells us about the sentiments in the market.
Based on the table above, reative to the Benchmark, investor's portfolio is overweight Stock A and Stock B and implicitly shorted Stock C (i.e. non existent in portfolio as it has 0% weighting)
Return(Portfolio) = Return(Benchmark) + Active Bets * Active Share; where;
Active Bets represents a binary decision between going Long (+1) or going Short (-1)
Active Share represents the quantum of the Active Bet represented by the amount of implied long / short
If an investor is placing an overweight bet on say Facebook relative to the benchmark, by how much they are overweight is represented by the Active Share and the fact that they are overweight is represented by the Active Bet (which is a binary +1 in this case). A portfolio that is overweight FB and a portfolio that is materially overweight FB are both expressing the same view (i.e. Active Bet) but at materially different quantums (i.e. Active Share), which will lead to different return outcomes for their respective portfolios.
Breaking down the return of a portfolio this way will inform the investor of the following:
How their stocks performed relative to the benchmark?
How much of their view of overweight or underweight impacted positively/negatively their portfolio?
Brings the focus on not only the stocks bought but also the stocks not bought. So, any lost opportunity from their view deviating from the benchmark becomes apparent.
A Market-Neutral strategy is one where investors avoid any market risk, for instance through hedging. Given the implicit long/short nature described in the table above, a Long Only Strategy is just a variant of a Market-Neutral Long/Short Strategy.
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