Abstract and Keywords
This article examines the differences between distributions associated with long-short investing and those associated with long-only investing. A tractable model is proposed for a case when unmanaged long-short portfolios go bankrupt or otherwise achieve an unacceptable result. The approximations are derived for the distribution of terminal value and the stopping time to a drawdown barrier and the probability of achieving a given terminal value conditional on avoiding a specified drawdown level. One of the ways to avoid the systemic and individual fund consequences of crowded trades is simply to avoid crowded trades in the first place. Those using hedge funds should take care that they are not doing the same strategy everyone else. Another approach would be to have a cash buffer that is used to avoid or lower trading into a crowded procyclical trade. The regulators or industry groups may require certain levels of cash buffer to moderate procyclical trading, and may allow leverage limits to drift within certain bounds to further relieve systemic pressure. The constant leverage is equivalent to constant proportions in the long and the short sides that is, a rebalanced portfolio. This portfolio has a different success surface than the unmanaged portfolio and never goes bankrupt.
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