Long–short equity strategies allow investors to benefit potentially from both undervalued and overvalued securities. The present study develops a normative portfolio model under the practical conditions that a market-neutral strategy entails. The offsetting long and short equity holdings are established jointly and without any constraints by the underlying market index. While accurately capturing institutional procedures for short selling, the model contains the analytical and economic properties as required for a ranking approach to filter out any undesirable securities under consideration. In view of its practical features, the analysis should be of interest to practitioners for assisting their long–short investment decisions.

In view of the acceptance of short selling of stocks as an investment tool in the portfolio context by a growing number of institutional investors in recent years, the present study considers both normative and market-equilibrium aspects of portfolio selection with short selling. Under the full-information covariance structure of security returns, the study accurately captures institutional procedures for short selling without sacrificing analytical tractability. While short selling enhances the portfolio's risk-return trade-off from a normative perspective, the equilibrium analysis reveals that there is a continuum of market-clearing prices within two boundaries for each security. Economic implications of the equilibrium pricing relationship are also explored in the study.