Short Segregation Quotes
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To control risk further, I replaced Bamberger’s segregation into industry groups by a statistical procedure called factor analysis. Factors are common tendencies shared by several, many, or all companies. The most important is called the market factor, which measures the tendency of each stock price to move up and down with the market. The daily returns on any stock can be expressed as a part that follows the market plus what’s left over, the so-called residual. Financial theorists and practitioners have identified a large number of such factors that help explain changes in securities prices. Some, like participation in a specified industry group or sector (say, oil or finance) mainly affect subgroups of stocks. Other factors, such as the market itself, the levels of short-term and long-term interest rates, and inflation, affect nearly all stocks. The beauty of a statistical arbitrage product is that it can be designed to offset the effects of as many of these factors as you desire. The portfolio is already market-neutral by constraining the relation between the long and short portfolios so that the tendency of the long side to follow the market is offset by an equal but opposite effect on the short side. The portfolio becomes inflation-neutral, oil-price-neutral, and so on, by doing the same thing individually with each of those factors. Of course, there is a trade-off: The reduction in risk is accompanied by limiting the choice of possible portfolios.
Edward O. Thorp (A Man for All Markets: From Las Vegas to Wall Street, How I Beat the Dealer and the Market)