Capturing Alpha: How Long/Short Strategies Can Improve Total Portfolio Outcomes

For Australian investors, the challenge of generating consistent excess returns in long-only equity has become increasingly apparent. The ASX 200 is dominated by a handful of large financials and resources companies, and the performance of the broader index is often driven by a small number of names. Managers who are underweight these names for fundamental reasons can find themselves persistently dragging on relative performance—not because their views are wrong, but because the benchmark composition works against them.

This is compounded by a global trend. As Goldman Sachs Prime Services noted in their June 2025 analysis, traditional active equity managers globally have struggled materially in recent years¹, with the average fund underperforming its benchmark by 1.5% in 2024 alone. The concentration of market returns in the largest stocks has been cited as a significant contributing factor².

Active extension strategies offer a structural response to this challenge—not bytaking more market risk, but by expanding the universe of alpha opportunities available to the manager.

The Mathematics of Extended Alpha

Consider a skilled manager with genuine stock-selection ability. In a long-only portfolio, that skill can be applied to long positions only. In an active extension fund—say, a 135/35—the same manager can express views on approximately 170% of the portfolio’s capital. This does not change the fund’s net market exposure (which remains at 100%), but it dramatically increases the number of active positions contributing to alpha.

The Morgan Stanley research framework describes this as expanding the “alpha hunting ground.” Their analysis demonstrated that the additional tracking error generated by a 35% active extension is modest—rising from approximately 3.5% for a long-only portfolio to around 4.3%—while the potential uplift in portfolio alpha can be more notable³.

For an Australian fund benchmarked to the ASX 200, this is a meaningful consideration. The short book can be used not just to express negative views on individual stocks, but to reduce sector concentrations, offset factor tilts (such as inadvertent value or small-cap biases in the long book), and facilitate pair trades between related names. These are tools that long-only managers simply do not have.

The Fund-Level Impact

One of the most compelling arguments for active extension strategies—and one that is often underappreciated—is the fund-level risk arithmetic.

For most institutional and high-net-worth portfolios, the dominant source of volatility is equity beta. Whether a portfolio holds 50% or 70% in equities, the co-movement of those holdings with the broader market typically accounts for 90% or more of total portfolio volatility. This means that incremental tracking error from an active equity strategy—which by definition is uncorrelated with the market beta—is largely absorbed at the total portfolio level.

In practice, moving from a long-only active equity allocation to an active extension allocation of equivalent size generally produces only a very small increase in total portfolio volatility, while the alpha contribution (weighted by the allocation) flows directly to the fund’s expected return. The asymmetry is favourable: a modest increase in tracking error in exchange for a potentially meaningful improvement in expected alpha.

Evidence From the Market

The Goldman Sachs data analysed across global hedge fund-managed beta-1 strategies is instructive. Over the five years to end-2024, active extension products generated annualised excess returns of 5.8%, compared to 2.3% for long-only products—a difference of more than 3.5% per year. The information ratio improvement was also significant, suggesting this outperformance was not simply a function of taking more risk.

In the Australian context, where market concentration is high and sector dynamics are well understood by experienced local managers, the conditions for short alpha generation are arguably even more favourable than in more efficiently priced global markets.

Practical Considerations for Advisors

For advisors considering an active extension allocation, several practical points are worth noting.

1. Active extension funds can typically sit within the same asset allocation bucket as traditional active equity—they are not alternatives, and do not require reclassification of the portfolio structure. The beta-1 profile ensures the portfolio’s equity exposure target is preserved.
2. Manager selection is critical. The short book requires genuine skill and operational infrastructure—it is not sufficient to simply be good at picking longs. Advisors should assess a manager’s track record on both sides of the book, their risk management discipline, and their organisational capability to manage short positions efficiently.
3. Fee structures for active extension products are generally more attractive than equivalent hedge fund offerings, and performance fees—where charged—are typically benchmarked against the equity index, ensuring alignment of interests.

Key Takeaway

Active extension strategies can offer a disciplined, practical way to improve the quality of equity alpha without meaningfully changing portfolio risk. The evidence is clear: more room for alpha opportunities, only marginally more tracking error, and a favourable trade-off at the total fund level. For advisors navigating concentrated markets and persistent long-only headwinds, this approach deserves serious consideration. It’s not about complexity for its own sake—it’s about giving skilled managers the tools to do what they do best.