Design Long-Short Strategy

Table of Contents

I. Long-Short Strategy………………………………………………………..……..2

II. Long Position in AHY.AX and Short Position in WOW.AX…………………2

III. Daily Return in WOW.AX and AYH.AX……………………………………..…..3

IV. Short position in WOW.AX and AYH.AX………………………………..……..4

V. Invest and short sell ASX 200 index…………………………...……………….5

VI. Long – Short Portfolio…………………………………………………………… 6 * Portfolio1………………………………………………………………….…………6 * Portfolio 2……………………………………………………………………………6 * Portfolio 3……………………………………………………………………………7

VII. Long – Short funds in Australian fund management companies…………8

VIII. Cost and Requirement of short selling…………………………………...……8

IX. Exhibit………………………………………………………………………………..9

X. Reference…………………………………………………………………….…….10

I. Long-Short Strategy
Long-short strategy is a hedge fund strategy in investment, which involves the long positon in a stock and short position in another stock. A Long position simply means buying an undervalued stock in a lower price that are expected to get an increasing value in it. On the other hand, short position in a stock means borrowing some shares from brokers who also borrows the share from institutional companies, then sell it immediately in the market and buy those stocks back at a lower price later. The profit is the different between the initial selling price and the later price when buying it back. The ideal situation for the long-short strategy is the long position in a stock will increase and the short position in another stock will decrease. If this happened, the position will become equal size and the hedge is the optimal choice.

II. Long Position in AHY.AX and Short Position in WOW.AX
According to ASX200 list, Woolworth and Asaleo Care belongs to the same industry sector called Consumer Staple, which are used to design the long-short strategy. Long- short strategy consists of buying an undervalued stock and shorting an overvalued stock. The P/E ratio is a fundamental tool to determining the valuation of stock whether it is overvalued or undervalued (P/E ratio =Market value per share/ Earning per share). The current price of AHY.AX in 07/03/16 is A$1.72 and the EPS over the last year is A$ 0.14. Then, the P/E ratio of AHY.AX is 12.286, which is lower than the industry sector 65.04 in the database of Reuters and assumes it is relatively more expensive or comparatively undervalued at its current price. This is one of the reasons why take long position in AHY.AX. On the other hand, EPS over the last year in WOW.AX is negative (-0.09), which means Woolworth isn’t profitable and the P/E ratio doesn’t exist or negative (Yahoo Finance 2016). As a result of it, taking a short position in Woolworth is an optimal choice without a doubt. (Graph 1) (Graph 2)
Apart from this, the tendency of the stock price in Woolworth (Graph 1) has decreased dramatically over the last year. In contrast, the share price of Asaleo Care (Graph 2) increased from A$1.5 at the beginning of 2016 to A$1.87 in 06/04/2016 (Yahoo Finance 2016). The tendency of a share can present a direct impression for forecasting the future price and making decision of short or long position. In term of the financial statement, the net income and cash position of Woolworth presents declining trend annually in Yahoo Finance. A company with weak finance like balance sheet or cash flow will be hard to improve its share price. The result is taking a short position in WOW.AX and long position in AHY.AX.
The macro-environment is the major factor in the estimating and forecasting the future tendency of share price. Due to the analysis of external environment in supermarket industry, Aldi has grabbed the market share with 11% compared to Woolworths’ 39% and a new entrant “Malaysia Giant” is inclined to enter the Australian market (Passport GMID 2016). It follows that Woolworth has a fierce competition in Australian market and face a threat of the new entrant. Therefore, the development of Woolworth will be influenced by the weak environment in Australian Supermarket industry. This is why choosing the WOW.AX to take the short position.

III. Daily Return in WOW.AX and AYH.AX (Exhibit 1)
The continuously compounded return is more accurate than the discrete rate of return, which defined as the logarithm of the daily return of the share price.
Rt=lnP(t+1)Pt
In broadly reviewing Asaleo Care’s share price (07 March 2016 to 07 April 2016), it is apparent that Asaleo Care has increase its share price as we expected compared with the down sloping in Woolworths’ share price over the period of time (Yahoo Finance 2016). Below is the fluctuation of daily return in both stock (WOW.AX and AYH.AX). In viewing the historic daily return for Asaleo Care, we can see that over the last 1 month most of the daily return are the positive number. Also, the average return of it over one-month convert at 0.37% compared with -0.36% for Woolworth. As a long short strategy, both of them play a positive role because AHY allows the investor take a long positon and WOW allows investor make a short position. The daily return of Woolworth reached the bottom at -2.62% in 29/03/2016 because Woolworth will dump the Homebrand name after the price gap with Aldi and Coles (Petrina Berry 2016). Due to the fact that Aldi has achieved the lower price in most reasonable quality good, Woolworth has faced with fierce competition and lost $972.7million last month. At the end, the stock price of Woolworth closed down 2.62% at $21.87.
According to the data analysis, the 1-day volatility of Woolworth is 0.0107685, which is less than that 0.0132116 in Asaleo Care. Volatility can determine the dispersion of a security’s daily return and standard deviation. As can seem from the line chart, Asaleo Care has the higher dispersion of return and standard deviation, which means higher risk the investors will face and the fluctuation of daily return is unstable.

IV. Short position in WOW.AX and AYH.AX
Essentially, short selling allows people to borrow an overpriced stock from brokers and then profit from buying back at a lower price. Every day, the Australian market will present the short position, which can be an indicator of investor’s sentiment. Short interest is the percentage that the number of shares shorted divided by the total number of shares outstanding. Below is the short interest of WOW.AX and AYH.AX during the time from 11 March 2016 to 11 April 2016 (Shortman 2016).

Typically, short interest can be a tool to determine the investor’s behaviour. As can be seen from the graph of Woolworth, the short interest has decreased over the period of one month. By contrast, the short interest in Asaleo Care present an upward sloping. On the other hand, the range of short interest in Woolworth is around 8%~10%, which is more than that in Asaleo Care about 4%~5%. Investors can use the short interest to make a prediction about the direction of company’s share price. The security with lower short interest such as Asaleo Care is less likely to experience a share price decline.
Due to the theory of short interest, the download sloping of short position may illustrate that most of investors think share price may go up. The tendency of short position is opposite to the share price over the last one year. However, stock price of Woolworths is actually decreasing during this time because the short sellers aren’t perfect and have some error in forecasting. In situation of graph in Woolworth, the time restriction and asymmetric information will lead to some standard error in judgement. The same theory can be also used to the graph of Asaleo Care. The short interest of Asaleo Care increases but the share price remains stable during one month.

V. Invest and short sell ASX 200 index
The ASX 200 can be measured as the movement of the market. One way to invest and short sell ASX 200 is ETF – called Exchange – Traded Fund. ETF is typically like a common stock in stock trades, which may experience the price change throughout a day. Also, the investors can buy or sell it based on their forecasting in the direction of the market. By using the long and short types in ETF, take the long position in index fund when you ‘re anticipating the share price index will rise and sell it for a higher price than you paid in the future. And if you think the market index is going down, you can short sell the ASX 200 index. Inverse ETF is more likely to take the inverse direction of the underlying assets, for example, each 1% drop in the metal will lead to 1% gain in the copper ETF.

Another way to trade the ASX200 index is through the future contract - called Index Future. The investors who want to hedge the risk of the portfolio during a certain of time will use ASX200 future. By shorting the future contract, stock investors can reduce the risk from downward sloping in share price index. The index future valued at A$25 per index point. For example, the hundred future contracts in ASX200 index are charged at the value of A$2500.

CFDs can also be a way of trading ASX200 index, called Contracts for difference. Trading CFDs doesn’t include buying or selling the underlying asset. Otherwise, you can trade number of units in market index, for example, $1 for each unit of point. When the 10-points movement in the ASX200, it means $10 changes in the value of contract. The difference between the CFDs and the share trades is the margin account. CFDs is a leveraged product, which means you need pay a small percentage of the total value contract to the institutional companies for opening a position (Yang 2013).

VI. Long – Short Portfolio

* Portfolio 1
The Long – Short portfolio 1 is taking long position in Asaleo Care, short position in Woolworth and long the cash instrument. The total amount of investment is $10million. The long –short portfolio (portfolio 1) is market neutral, which means the beta of portfolio 1 is zero. Assume x is the amount of long position in Asaleo Care, -y is the amount of short potion in Woolworth, so that y is the cash instrument. Also, the one-year history data show the βA (Asaleo Care) is 0.7854, βW(Woolworth) is 0.9683 and βC is zero. 1. βp=x10×βA+-y10×βW+y10×βC=0 2. $10=X
From those two equation, we can calculate X=10, Y=8.1111. As a result of it, The Long – Short portfolio 1 is long position in Asaleo Care at amount of $10 and short $8.1111in Woolworth. * Portfolio 2
2.1 The portfolio 2 is the dollar neutral portfolio, which the long and short position of the trade are the equal dollar amounts. In order to accommodate the requirement of client, we need to construct the portfolio and get the minimum value of tracking error. Tracking error is the standard deviation of the active returns (the difference between portfolio and market return). The formula is:
TE=ω=√Var(Rp-Rb)
Let the amount of long position in Asaleo Care is X (variable value), the short position in Woolworth is –X based on the equal amount in dollar neutral. Apart from this, the fixed value of investing in index is $10million and the cash instrument after short positon is X. The total amount of investment is 10+X−X+X= 10+X. Therefore, the portfolio return is:
Rp=x10+x*Rl-x10+x*Rs+1010+x*Rb

The above is the graph of tracking error with variable X with one-year history data. In excel, the history data will show the different level of tracking error based on the different level of X invest in AHY (horizontal axis). In conclusion, the tracking error is going up by the increasing in variable X invest in AHY.AX. For example, when long $0.5 million in AHY, short $0.5 million in WOW and invest $10million in index, the tracking error get the minimum value of 0.001147329.
2.2 Total amount of investment = amount invest in index +amount in long positon –amount in short position +cash instrument from short selling stock= $10+$3−$3+$3=$13. The formula is: βp=1013*βb+313*βA-313*βW+313*βc βb(Market Index) is 1, βA (Asaleo Care) is 0.7854, βW(Woolworth) is 0.9683 and βC is zero. As the result, the beta of portfolio is 0.727. * Portfolio 3
The minimum variance portfolio X= (mA, mB, mC), which are the weight for three assets (AHY, WOW and ASX200). The formula is:
VAR (p)= + + 2 w1w2COV(1,2)
s.t. XA+XB=1
The Lagrangian function of the minimum variance (Zivot, E. 2013) is:
LXA,XB, λ= + + 2 w1w2COV1,2+λXA+XB-1=0
Let’s make a first derivative of the Lagrangian function and all equal to Zero.
∂L∂WB=2WAσA2+WB2σAB+λ=0
∂L∂WB=2WBσB2+WA2σAB+λ=0
∂L∂λ=WA+WB-1=0
Following this, those three function can be described as a matrix representation or Am*Xm = b 2σA22σAB12σAB2σB21110 * WAWBλ = 001 The solution of Xm =A-1 *b, use excel to calculate inverse A and the get each weight of stocks (see Exhibit 2). In conclusion, Weight of AHY is 0.46697578, Weight of WOW is 0.53302422. The Beta of portfolio is: βp=0.46697578*βA+0.53302422*βW=0.88289 The return of those three portfolio is Rp1=0.662%, Rp2=0.03769% and Rp3= -0.01910768%. According to the Beta shows above, the portfolio 1 is the market neutral portfolio, which the beta is equal to zero compared with the other two portfolios. As a result of it, the portfolio 1 is the optimal portfolio.

VII. Long – Short funds in Australian fund management companies

The investment management industry in Australian become one of the largest over the world. The number of fund management companies with long short funds operated in Australia is over 130 (IBISWorld 2009). The top 30 Australian fund management companies dominate 85 percent of the market cap under fund management. In the statistic of 2009 Australian total funds under management, Commonwealth/Colonial Group reach the top with A$105.1billion compared with other management companies. The following is Macquarie Bank Group who manage A$79.2billion and get 7.5% in market share. The third is State Street Global Advisors who get A$78.9billion. The difference between them is small. The remaining top 10 investment management firms is Vanguard Investments Ltd, AMP Group, BlackRock, ING/ANZ Group, BT Financial Group, AXA Australia/AllianceBernstein and PIMCO. VIII. Cost and Requirement of short selling
In the transaction of short sales, the investors bearish on a stock and borrow them from the brokers, then sell them at a higher price in the future. The process is that you borrow the shares from broker who borrow from other investor. Later, you will buy back the stocks and those stocks are used to repay to the investor who lent to the broker. If the stock pays dividends, the short seller needs to pay those back to the lenders. Therefore, the dividend fees are one of cost of short selling. Another cost is Money Rate (about 1% less than prime) that Brokers charge an interest rate from the investors based on the amount of shares the investors borrowed (Jacobs 1999).
Next to Margin Account, it is used as a collateral on the short sellers for insuring that the shares borrowed will be back to the lenders in the future. Typically, the initial margin requirement is the minimum equity percentage required based on the total short account. Margin requirement is 50% set by the Federal Reserve Board, which means the short sellers have to pay 150% of the total value of short account at the initial time. Apart from this, the maintenance margin is required over the trading time that is 30% of the equity. If the value of equity falls below the maintenance margin, the broker will issue a margin. The investors have to pay additional funds to meet the Maintenance Margin and increase the total amount to 50%. Otherwise, broker can close the position. For example, short selling 10 share for each price $10 - $100 total, margin account is 50% of it - $50 equity. There is now total $150 in the account. If price go up to $12, the short sales will lose money and attach the maintenance margin. The equity is $150-$12×10= $30 and margin is $30/ $120= 25% which is less than 30%. At that time, the investor can choose cover or uncover the short position. If covered, the loss is the $20 plus dividend paid to the lenders and the brokerage commissions or money rate for brokers.

The Preference and Daily Return of WOW.AX and AHY.AX (Exhibit 1)

Minimum Variance Portfolio (Exhibit 2)

Rp1=$1010*0.37%-$8.111110*-0.36%=0.662%
Rp2=1013*-0.17%+313*0.37%-313*-0.36%=0.03769%
Rp3=0.46697578*0.37%+0.53302422*-0.36%=-0.01910768% IX. Reference
Passport GMID. 2016, Grocery Retailers in Australia, Category Briefing,
January 2016, viewed 10 March 2016, Euromonitor International Passport
GMID.

Yahoo Finance 2016, Historical Price of Asaleo Care Ltd, viewed 09 April 2016, <https://au.finance.yahoo.com/q/hp?s=AHY.AX&a=02&b=7&c=2015&d=02&e=7&f=2016&g=d>

Yahoo Finance 2016, Historical Price of Woolworths Ltd, viewed 09 April 2016, <https://au.finance.yahoo.com/q/hp?s=WOW.AX&a=02&b=07&c=2015&d=02&e=07&f=2016&g=d>

Petrina Berry. 2016, ‘Woolies shelves Homebrand name’, Yahoo News, 29 Mar, viewed 14 April 2016,
<https://au.news.yahoo.com/a/31207159/woolies-shelves-homebrand-name/>

Shortman 2016, WOOLWORTHS LIMITED ORDINARY, view 10 April 2016, <http://www.shortman.com.au/stock?q=WOW>

Shortman 2016, ASALEO CARE LIMITED ORDINARY, view 10 April 2016, <http://www.shortman.com.au/stock?q=AHY>

Yang, J. Y., & Lepone, A. 2013. Informational Role of Market Makers: The Case of Exchange Traded CFDs, Journal of Empirical Finance, 23.

Zivot, E. 2013, “Portfolio theory matrix algebra,” viewed 10 April, 2016, <http://faculty.washington.edu/ezivot/econ424/portfolioTheoryMatrix.pdf>

IBISWorld 2009, Funds Management (except Superannuation Funds) in Australia, Industry Report, September 2009, viewed 15 April 2016

David, Chin. James, Boynton. 2010, Investment Management Industry in Australia, Australian Trade Commission, Sydney, ISBN: 978-0-9807059-1-1, view 17 April 2016,
<file:///Users/Kui/Downloads/Investment-Management-Industry-in-Australia%20(4).pdf>

Jacobs, B. I., Levy, K. N., & Starer, D. 1999, Long-short portfolio management: An integrated approach, The Journal of Portfolio Management, vol. 25, no. 2, 23-32.