manager's index, the active manager's return is reconstituted as a long position in the index, a long position in a long/short portfolio, and a short position in cash. The long/short portfolio is simply the difference between the security weights in the actual portfolio and the benchmark. The difference between the long/short portfolio and cash can now be compared to the excess return on hedge funds (i.e., the hedge fund return relative to cash rates). There are three fundamental characteristics of hedge fund managers that give them the potential to add value relative to their traditional active management counterparts. First, hedge fund managers do not face the same constraint on short positions that traditional active managers face. For example, suppose that a hedge fund manager and a traditional active manager have the same views on two securities such that one stock appears as a long position for overweight relative to the benchmark) and the other appears as a short position (or underweight relative to the benchmark). If the active manager has a net short constraint, then the potential to generate higher excess returns can be reduced. Table 26.1 illustrates this point with a simple hypothetical example. The figures in Table 26.1 show the expected return for two optimized portfolios, based on the same assumptions regarding the returns to individual securities. Risk, as measured by the volatility of portfolio return, is the same for both portfolios. The first portfolio, labeled Unconstrained Optimal Portfolio, assumes that the managers can take long and short positions irrespective of size. The second portfolio, Constrained Optimal Portfolio, imposes a constraint on the size of the short positions. As Table 26.1 illustrates, the impact of the short constraint is to reduce the potential to add value: The expected return on the unconstrained portfolio is higher than that of the constrained portfolio for the same level of portfolio volatility. TABLE 2G.1 Impact of Short Constraints-A Hypothetical Example       Correlation   Volatility Expected Return   Asset 1 Asset 2 Asset 3     Asset 1 Asset 2 Asset 3 1.0 0.2 0.3 0.2 1.0 0.1 0.3 0.1 1.0 13.0% 3.0 16.0 10.0% 5.0 -5.0 Unconstrained Constrained Optimal Optimal Portfolio Portfolio   Asset 1 21% 29% Asset 2 99 71 Asset 3 -20 0   100% 100% Expected return 8.0% 6.5% Volatility 4.7 4.7