The great Cliff Asness recently wrote a piece about the difficulty in explaining a market-neutral portfolio at an intuitive level. The problem is more fundamental than explaining the performance--as troubling as that can be. It is also a problem just helping people understand what they own. Here is my attempt to help him out.
Consider a bunch of guys in a basketball gym. Suppose I was an investor in their performance. First just think about all of them simply shooting baskets like in a warm up before a game. If I could “invest” by paying $1 each time one of my chosen players shot and making a return of $2 each time one of my chosen players made a basket, I would want to pick the best shooters and avoid the worst. I would be making money based on their shooting accuracy. At the extreme I would want to pick Stephen Curry and Lebron James (pick a couple of darling stocks and go all in with them). However, this is hard to do because the star performers are not that obvious—this is after all just a bunch of strangers in a basketball gym not a bunch of strangers plus a couple of NBA all stars. More likely I would need select quite a few players based on some metrics for selection and “invest” in their shooting percentage (build a long portfolio of many stocks).
That analogizes to the typical portfolio. But what if instead I deliberately chose two teams from the group of guys and had them play a game. My investment's return would then be determined by which team wins and by how much. I gain more as my team wins by more points and I lose more as my team loses by more points. Now my ability to pick the teams (stacking the talent in my team) is the deciding factor of my success and I am essentially long the team I own and short the opponent. From the standpoint of each individuals' shooting percentage (the first approach that analogized a long stock portfolio) my long/short investment isn't highly intuitive, but when viewed as a group against a group it probably is.
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