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 The new rage is all about 130/30 strategies.1 Over the last few years, 130/30 and related strategies have grown from nothing into a burgeoning industry, with 65 managers now accounting for an estimated $50 billion in managed assets (as of March 2007).
130/30 strategies have a special appeal in today's marketplace, as regulations have changed and expectations for long-term equity returns have diminished since the roaring 1990s. In this environment, investors of all stripes—from pension plans to individuals—are turning to alternate strategies to seek out incremental returns.
The conventional approach to operate a 130/30 strategy directs a manager to marry a 130 percent long position with a 30 percent short exposure. The result is a 100 percent net long exposure, "beta-one" portfolio with greater alpha potential. Importantly though, a conventional 130/30 strategy is not the only—and perhaps not even the optimal—way to achieve a desired high return within a 130/30 profile.
Revolution Evolution2
Interestingly, while some consider the 130/30 strategy a hedge-fund-like strategy, most 130/30 providers to date have emerged from long-only, mainstream asset management companies. These managers are often quantitatively oriented and tend to have strong historical long-only track records.
These managers have largely created their 130/30 portfolios by expanding and extending existing long-only management strategies. The 130 percent long exposure is generated by augmenting existing overweight positions as well as adding new long positions, while the 30 percent short exposure is created by converting previously underweight or zero-weight positions into outright shorts (and adding new shorts in related stocks).
This approach works well for managers who have outperformed in a traditional, long-only framework; it allows them to amplify returns using familiar, relative-return investing strategies. As the popularity of 130/30 strategies grows, however, new types of managers—exchange-traded fund (ETF) providers, hedge funds and even underperforming long-only equity mangers—may be tempted or possibly compelled to move into the space. For these managers, a conventional 130/30 approach may not naturally fit, and a new (and potentially more sophisticated) approach is needed.
Alternate 130/30
Common sense suggests—and quantitative backtesting confirms—that these managers may be better served by creating 130/30 portfolios in two distinct segments:
• A 100 percent long-only portfolio, and
• A high-conviction 30 percent long/30 percent short, market-neutral strategy.
Unlike conventional 130/30 strategies, an alternate 130/30 approach does more than just expand on long-only portfolio management. Within the market-neutral segment of the portfolio, managers have even greater freedom to generate excess returns. Alternate 130/30 managers are freed from market-capitalization weighting, style guidelines and other strictures that constrain long-only (and by extension, conventional 130/30) portfolios.
It is this newfound freedom that fundamentally distinguishes the alternate 130/30 structure from conventional 130/30 platforms. Indeed, even a previously underperforming long-only manager could now improve client returns and possibly generate significant new alpha within a new alternate 130/30 strategy—while reducing active management exposure to only 60 percent of client funds (i.e., 30 percent long +30 percent short baskets).
Importantly, an alternate 130/30 strategy may rationally employ a variety of instruments to achieve the 30 percent short exposure, including individual stocks, broad market index ETFs and sector-focused ETFs. Each approach can generate a risk/return profile similar to that of a conventional 130/30 strategy, including net alpha generation between 2 percent and 9 percent annually. This article attempts to determine an optimal way to implement an alternate 130/30 strategy.
Footnotes
1 130/30 refers to all related enhanced long/short strategies that net to 100 percent net long, beta-one market exposure. Some managers may choose 120/20 or 140/40, but 130/30 is emerging as the standard—and as the category name.
2 Article based on a white paper by same author, as produced by the Index Research Group. The full white paper is available at www.indexresearchgroup.com.
3 The S&P 500 is used, as it is the most commonly used benchmark of U.S. equity returns. Other benchmarks—and ETFs—would also be applicable.
4 Provided by Timeous LLC.
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