# The best way to build a long/short portfolio

For several mutual funds, I have their performance (in %) as well as their TNA (in bn) on a monthly basis (months 1 to 193).

Thanks to a previous step, I know for each fund, each month, whether I should take a long or a short position (or do nothing). What do you think is the best way to build my long/short portfolio? Should I have 2 portfolios (one long and one short)? How do I calculate its return?

Thank you very much for your help,

Vanie

EDIT QUESTION:

I'm evaluating a strategy ex-post. In a few words, I split funds into different clusters using a dynamic clustering method. In fact, I'm interested in disconnections. The principle: if a fund goes out of its reference cluster (I set 2 periods/month in a row) then I can take a position: long or short, depending on whether it outperforms or underperforms its reference cluster (I compare the fund's return with the average return of its cluster). This until he is back in his cluster. For example, for long positions, I hope that a found that underperforms its cluster, will "go up" to return to it.

From there, I create a portfolio with the returns (weighted with TNA) of the long and short positions.

I've done all these steps but I get results that are not very logical (extreme). Do you think there is a problem somewhere?

• If you know for each fund, each month, whether I should take a long or a short position (or do nothing) then why are you asking What do you think is the best way to build my long/short portfolio? May 4, 2020 at 16:13
• Thank you for your comment! But do I have to make two separate portfolios? How do I calculate the return on this (these) portfolio(s)? May 4, 2020 at 16:18
• You can do whatever you want to do. I don't see a reason to segregate the long and short positions into two separate portfolios but you can do so if so inclined. Here's an article on how to calculate the return on this (these) portfolio(s) May 4, 2020 at 18:08
• To be frank, your question doesn't seem to make sense. This question seems a lot like asking, "I've designed and built my own airplane; however, how do I fly it?" For one, if you're knowledgeable enough to know whether to take a long or short position, surely you're knowledgeable enough to come up with an educated guess as to your returns. For two, since you're the only one who knows what your technique is, you're the only one who can possibly figure out how to put it to use and what its performance will be. May 5, 2020 at 23:56
• The only way anyone could possibly hope to answer your question is if you describe your technique for determining whether to go long or short. May 5, 2020 at 23:56

I have their performance (in %) as well as their TNA (in bn) on a monthly basis (months 1 to 193).

Thanks to a previous step, I know for each fund, each month, whether I should take a long or a short position (or do nothing).

If you are using information that was not available at the time of the back-test's transactions, the strategy is not reproducible going forward. No one can use next month's return to build their portfolio today. They do not know next month's return.

In practice, you do not know whether your should take a long or short position.

What do you think is the best way to build my long/short portfolio?

If you could see the future, you would buy whatever will have the highest percentage gain.

How do I calculate its return?

Return = (gain or loss) / capital.

• Thank you @Charles Fox your answer, I edited my post to be more complete. May 6, 2020 at 17:47
Thanks to a previous step, I know for each fund, each month, whether I should take a long or a short position (or do nothing). What do you think is the best way to build my long/short portfolio?

You know this only for the past, not for the future.

If you do not want to expose yourself to potentially unlimited losses, I will argue that the "short" part of your portfolio should be zero.

Any nonzero short-selled position has potentially unlimited losses.

In particular, no stop-loss order is going to limit your losses in every single case. It is possible there is a discontinuous jump on the price of an asset, and thus, if the price skyrockets in a short amount of time, the stop-loss order will not act quickly enough, and you need to buy back the short-selled security at a very great price.

Based on this, the "long" part of your portfolio should be equivalent to your investable assets.

• Thank you for your answer, I edited my post to be more complete. May 6, 2020 at 17:47

In my world, there are a few reasons for shorting.

(1) I think that the security is going to drop in price and therefore, I short it.

(2) It's highly correlated to another security, the spread between the two has widened and I am trying to capture some reversion to the mean. This long/short pairs strategy is far more effective in a volatile market (see 2008, 2009, when the China tariffs were implemented, the December 2018 rising rates inverted yield curve correction, and March of this year).

A subset of (2) is that I'm shorting a smaller position of a correlated issue as a hedge going into ex-div.

I'm not big on calculating statistical returns on complex individual positions. The objective is to make a profit from trading and the stats won't increase the yield on the next trade. Find good trades and do your best to limit their losses when wrong.

• Is your answer "you shouldn't build the short portfolio at all"? If so I think you should say that explicitly, it doesn't look like it actually addresses the question at present. May 5, 2020 at 19:54
• The question is about building a long/short portfolio and my (2) addresses that. How did you get from that to" you shouldn't build the short portfolio at all"? That conclusion has nothing to do with the question or my answer. May 5, 2020 at 20:02
• But doesn't the question assume the constituents of the portfolio are already known? May 5, 2020 at 20:17
• You can build a long/short portfolio with individual equities. You can also do the same with ETFs that have different constituents (which are known). It can be 1:1 long/short or biased long or biased short, share weighted or dollar weighted. Anything that you want. Until the OP specifies exactly what he's doing, it depends on what you or I guess at what he is constructing and that leaves a lot of room for interpretation. That's why I wrote "In my world"... May 5, 2020 at 20:51
• Thank you for your answer, I edited my post to be more complete. May 6, 2020 at 17:50