Sizing Matters: Optimal Scaling of Long and Short Exposures in Equity Portfolios

Considering its material impact on long–short portfolio outcomes, the scaling of long and short exposures is given disproportionately little attention by many investors, and the commonly implemented dollar-neutral exposure matching is empirically suboptimal from an absolute return, risk-adjusted return, and market neutrality perspective. Accordingly, the author proposes two alternative scaling schemes, one that delivers the maximum Sharpe ratio and another that delivers market neutrality. Applying these to Fama–French five-factor long–short portfolios informs another perennial question in factor investing: whether short legs are better implemented with stocks or index futures. Previous research suggested that index futures were preferable because of the higher volatility and lack of diversification among stocks with poor factor characteristics; however, this conclusion is entirely dependent on the sizing of the long and short legs, and when applied to short stocks, the author's proposed scaling mechanisms deliver both higher absolute and higher risk-adjusted returns than dollar-neutral long–short, long-minus-market, and market-minus-short portfolios.