**By Corey Hoffstein, Newfound Research**

**The Importance of Long/Short Portfolios**

Anybody who has read our commentaries for some time has likely found that we have a strong preference for simple models. Newfound’s Justin Sibears, for example, has a knack for turning just about everything into a conversation about coin flips and their associated probabilities. I, on the other hand, tend to lean towards more hand-waving, philosophical arguments (e.g. The Frustrating Law of Active Management[1] or that every strategy is comprised of a systematic and an idiosyncratic component[2]).

While not necessarily 100% accurate, the power of simplifying mental models is that it allows us to explore concepts to their – sometimes absurd – logical conclusion.

One such model that we use frequently is that the *difference between any two portfolios can be expressed as a dollar-neutral long/short portfolio.* For us, it’s long/short portfolios all the way down.

This may sound like philosophical gibberish, but let’s consider a simple example.

You currently hold Portfolio A, which is 100% invested in the S&P 500 Index. You are thinking about taking that money and investing it entirely into Portfolio B, which is 100% invested in the Barclay’s U.S. Aggregate Bond Index. How can you think through the implications of such a change?

One way of thinking through such changes is that recognizing that there is some *transformation* that takes us from Portfolio A to portfolio B, i.e. Portfolio A + X = Portfolio B.

We can simply solve for X by taking the difference between Portfolio B and Portfolio A. In this case, that difference would be a portfolio that is 100% long the Barclay’s U.S. Aggregate Bond Index and 100% short the S&P 500 Index.

Thus, instead of saying, “we’re going to hold Portfolio B,” we can simply say, “we’re going to continue to hold Portfolio A, but now *overlay* this dollar-neutral long/short portfolio.”

This may seem like an unnecessary complication at first, until we realize that any differences between Portfolio A and B are entirely captured by X. Focusing exclusively on the properties of X allows us to isolate and explore the impact of these changes on our portfolio and allows us to generalize to cases where we hold allocation to X that are different than 100%.

**Re-Thinking Fees with Long/Short Portfolios**

Perhaps most relevant, today, is the use of this framework in the context of fees.

To explore, let’s consider the topic in the form of an example. The **iShares S&P 500 Value ETF (IVE)** costs 0.18%, while the **iShares S&P 500 ETF (IVV)** is offered at 0.04%. Is it worth paying that extra 0.14%?

Or, put another way, does IVE stand a chance to make up the fee gap?

Using the long/short framework, one way of thinking about IVE is that IVE = IVV + X, where X is the long/short portfolio of active bets.

But are those active bets worth an extra 0.14%?

First, we have to ask, “how much of the 0.18% fee is actually going towards IVV and how much is going towards X?” We can answer this by using a concept called *active share*, which explicitly measures how much of IVE is made up of IVV and how much it is made up of X.

*Active share *can be easily explained with an example.[3] Consider having a portfolio that is 50% stocks and 50% bonds, and you want to transition it to a portfolio that is 60% stocks and 40% bonds.

In essence, your second portfolio is equal to your first plus a portfolio that is 10% long stocks and 10% short bonds. Or, equivalently, we can think of the second portfolio as equal to the first plus a 10% position in a portfolio that is 100% long stocks and 100% short bonds.

Through this second lens, that 10% number is our active share.

Returning to our main example, IVE has a reported active share of 42% against the S&P 500[4].