|
 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.
Building An Alternate 130/30 Portfolio
100 Percent Long Core
The heart of the 100+30/30 portfolio is a 100 percent long market core. This core assures investors will maintain exposure to the broader market. Because an alternate 130/30 strategy can even be used by managers who have not historically outperformed the market, the most applicable approach is to use a passive instrument to achieve the core 100 percent long exposure.
A manager who regularly generates below-market, long-only returns (which is to say, the majority of managers) would automatically increase gross performance to or near benchmark levels by switching to a passive 100 percent long core. That manager would also benefit from the removal of certain costs associated with active management in this core position. Finally, they have the potential to generate alpha in the 30/30 component above an already-guaranteed 100 percent long market return.
Market-Neutral Component: Levered 30 Percent Long
The 30 percent levered long section of the portfolio is, by definition, a stock-picking section of the portfolio. Although one can imagine scenarios in which managers would use sector bets or other strategies in this portfolio, in practice, managers rely on stock selection.
As mentioned, the advantage of the 30/30 market-neutral component is that it grants portfolio managers significant discretion—more discretion than they have in long-only or conventional 130/30 formats. Nonetheless, risk control remains important. Risk control parameters should be limited, but certain general parameters that help maintain basic stock diversification are worth enforcing.
Long Stock Number: The goal of a market-neutral strategy is to hedge away market risk from a portfolio to allow the alpha-generation potential of the long stock-selection component to shine through. A portfolio of five or 10 stocks cannot be effectively hedged in a market-neutral way. The exact number of stocks that managers should use in the levered 30 percent long basket is a topic for others to debate, but it is estimated (and anecdotally confirmed) that a minimum of 30 to 50 stocks is required to allow reasonable hedging.
Weighting Components: This article assumes equal weighting as the default weighting for a market-neutral portfolio. Stock weighting, however, can vary based on managerial confidence and discretion, as long as the portfolio remains sufficiently diversified among the 30 to 50 components.
Long Sector Constraint: To generate a meaningful return within the relatively small market-neutral portfolio, alternate 130/30 managers must have the discretion to focus on their best ideas. It is entirely possible that a manager's approach does not favor certain sectors or that some sectors do not currently present attractive opportunities. Applying a minimum sector weighting is therefore inappropriate (a similar argument applies to other risk factors).
There is, however, merit to a maximum sector exposure limit. As the S&P 500 Index is divided into 10 sectors, the maximum permissible sector position should be set far above 10 percent to avoid establishing an implicit minimum sector weighting. A maximum sector exposure of 33 percent is suggested, which means that managers will always choose long positions from more than three sectors.
Market-Neutral Component: 30 Percent Short
To execute an alternate 130/30 strategy, the portfolio manager must know how to successfully short—which can be a challenge. It is much more difficult to select short positions than long holdings. Shorting is not simply the opposite of long investing. A stock sold short is actually a loan, and creditors are not always accommodating.
Stocks can be recalled; they might not be available; they might cost a lot or a little money to borrow (i.e., they might have different short rebate classifications embedded in the "spread through the middle"); liquidity can dry up; and there can be short squeezes. In addition, new client contracts/risk disclosures are required, as well as new systems (e.g., ordering, execution, risk management, data and compliance). Even an excellent long-only manager may not excel as a short investor; it's simply a different game.
With alternate 130/30 strategies, the goal of the 30 percent short component is not solely profit (indeed, the average dedicated short hedge fund generates net losses long term). Instead, the short position is also intended to hedge market exposure risk within the 30/30 market-neutral component, thus allowing alpha generation from the long stock-picking portion of the portfolio to more smoothly and fully fall to the bottom line.
Shorting Methods
Three short methods are considered herein: S&P 500 ETF, S&P 500 sector ETFs and individual stocks.3 Each approach achieves the key objective of hedging the market exposure of the long portfolio, but does so in different ways that generate different return profiles.
Short Method 1: S&P 500 ETF
S&P 500 ETFs are the bluntest financial instrument available to hedge long U.S. stock exposure. Shorting this instrument in a 30/30 leveraged portfolio will hedge away the entire broad market from the 30 percent long basket.
There are drawbacks to this hedging scenario. This methodology is significantly damaging to net absolute returns. The S&P 500's average total return has varied between 8 percent and 10 percent over the long term. Moreover, using an S&P 500 ETF to hedge a long basket of equally weighted stocks will not fully hedge long sector exposures.
There are, however, benefits to this approach as well. For one, portfolio turnover is limited, as S&P 500 ETFs can theoretically be shorted once and maintained permanently. S&P 500 ETFs also benefit from low expense ratios (less than 0.10 percent, annually), huge liquidity and tight spreads. Furthermore, S&P 500 ETFs are cheap to borrow (i.e., they qualify for General Collateral classification, with costs usually less than 20 basis points [bps] annually).
A variety of S&P 500 ETFs exist, the most popular and liquid of which is the S&P Depository Receipts 1, or SPDR, which trades on the American Stock Exchange (AMEX) under the ticker SPY. The SPDR will therefore be used in the quantitative modeling platform to follow.
Short Method 2: S&P 500 Sector ETFs
Sector ETFs are also blunt instruments for hedging long stock exposure. Their more granular focus, however, allows for long-basket hedging at the sector level. This could allow more of the long basket's positive return to flow through, while also improving the net alternate 130/30 portfolio tracking versus its benchmark.
Portfolio turnover could also be favorable. Sector exposures in the 30 percent long basket are unlikely to change wildly from month to month, so turnover in the hedged ETFs is likely to be lower versus a comparable strategy that shorted individual stocks. Sector ETFs also benefit from low expense ratios (about 0.25 percent annually).
There are drawbacks to sector hedging, though. For example, prime brokers cannot as easily offset open long sector ETF positions as they can with broad market ETFs. As a result, sector ETFs command higher short rebates, raising costs (usually about 50 bps annually).
A variety of sector-focused ETFs exist, of which the S&P 500 Select Sector SPDRs are the most liquid and popular. Therefore, the Select Sector SPDRs are used in the modeling platform to follow.
Short Method 3: Individual Stocks
Shorting individual stocks is the method most likely to maximize incremental return, provided the underlying stock selection system is profitable. Hedging with individual stocks can potentially augment (not always reduce) levered long-term gains with additional gains from short stock positions. Direct stock trading also benefits from the lack of expense ratios.
There are distinct negatives, however, involved in shorting individual stocks. While the short stock portfolio will hedge long sector exposure, some net sector exposure will likely remain, which leads to higher tracking error. As well, individual stocks command widely differential short borrowing costs (e.g., Special and Negative Rebate classifications can sometimes apply, thus ballooning borrowing costs).
Not surprisingly, hedging with individual short stocks will also increase portfolio turnover, as both sides of the 30/30 strategy are actively managed. Additionally, there is a heightened chance of a lending recall when shorting individual stocks, though that risk can be minimized by restricting short stocks to better-known companies.
Final Alternate 130/30 Consideration: Stop Losses
No absolute return strategy will be successful all the time. Whether a manager's strategy has lost potency or markets become destructively volatile, losses will occur. Indeed, long-term net returns are often materially reduced due to occasional breakdowns in the performance of selected stocks.
Stop losses are an effective, easily executed risk-control system to manage the unforeseen within the market-neutral 30/30 component. Others may debate the exact level of a stop-loss discipline, but it is recommended that stop losses be enforced at both the long- and short-basket levels, as well as at the market-neutral 30/30 portfolio level.
Figure 1 therefore summarizes an optimal alternate 130/30 portfolio construction.
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.
Quantitative Testing
This optimal alternate 130/30 portfolio construction has been quantitatively tested. The hypothetical backtest was implemented employing a passive 100 percent long market core, an active equity selection process for the 30 percent long portfolio and a 30 percent short portfolio using one of three methods: S&P 500 SPDR, S&P 500 Select Sector SPDRs or individual stocks. The existence of these contracts, as well as their current expense ratios, is considered constant throughout the model test.
As previously referenced, an SPDR ETF is used for the passive core. For the 30 percent long levered basket, a quantitative, active stock selection strategy has been created using stock-specific, multifactor data, broadly described as earnings, price and valuation.4 The strategy considers only mid- and large-cap (market cap > $1.5 billion) liquid stocks. It selects approximately 50 long stocks (and short, where appropriate) each month and rebalances the portfolio as such.
The database used spans 1992–2006 and contains no survivor bias. All returns are presented net of management fees, performance fees, slippage, margin, short rebates and commissions. Sales and administration fees are excluded. Figure 2 details performance data for the various backtest scenarios, while Figure 3 demonstrates the same data in graphical form.
Short Method 1 Results: S&P 500 SPDR
Using this modeling system, an alternate 130/30 product design employing a short S&P 500 SPDR hedge would have beaten the S&P 500's total return by a net 2.8 percent per year over the period studied. Volatility was higher than that of the S&P 500 alone (slanted toward relative upside rather than downside risk), but both the Sharpe ratio and information ratio improved. Net alpha generated was positive 2.8 percent per year, while beta and correlation remained close to 1.0. Turnover was 170 percent, roughly equivalent to gross exposure. Nonsales fees were 1.3 percent of client assets—twice that of long-only management.
Short Method 2 Results: S&P 500 Sector SPDRs
An alternate 130/30 product design employing the S&P 500 SPDR as a short hedge would have beaten the S&P 500's total return by a net 2.3 percent per year over the period studied. Standard deviation was lower than that using the S&P 500 ETF hedge (14 percent vs. 14.6 percent), but still slightly higher than the S&P 500 itself (13.6 percent). Results were favorably slanted toward relative upside rather than downside risk. Turnover rose to 240 percent a year, alpha generation was positive at 2.6 percent per year, and beta and correlation remained close to 1.0. Nonsales fees were also 1.3 percent of client assets.
Short Method 3 Results: Individual Stocks
Not surprisingly, incremental returns were maximized using a robust stock selection shorting strategy. This 130/30 portfolio beat the S&P 500 total return by a net 7.2 percent per year. Volatility was lower than the S&P 500, at just 12.6 percent, while the Sharpe and information ratios were high. Tracking error in this portfolio increased, however, as beta strayed from the benchmark to 0.8. As expected, portfolio turnover was also high at 340 percent. Investors may or may not accept higher turnover and tracking error in order to obtain demonstrated outperformance. Nonsales fees rose to 1.6 percent of client assets.
Other Approaches: Vary Gross Exposure Or Combine Short Techniques
It is possible to obtain many of the benefits of hedging with individual stocks while better tempering turnover and tracking error. For example, a manager could employ Short Method 3 within a smaller 120/20 mandate. Such an approach bested the S&P 500 by a net 4.5 percent per year, while reducing tracking error below that of even Short Methods 1 and 2. The Sharpe and information ratios remained high, while beta and correlation returned closer to benchmark. Turnover dropped to 225 percent, while nonsales fees stayed strong at 1.2 percent.
Alternatively, the three shorting methods could be combined. In an alternate 130/30 strategy, it pays to be creative. Hedging with individual stocks and sector ETFs would have bested the market by a net 1.7 percent per year, while reducing tracking error to just 3 percent. Nonsales fees would still have risen to 1.1 percent of client assets.
How Does Alternate 130/30 Stack Up?
It is estimated that an average conventional 130/30 strategy could generate approximately 4 percent alpha above benchmark. Such a performance optimistically assumes that the conventional 130/30 manager generated net 2 percent alpha in the former long-only mandate, replicated that performance within the 30 percent long basket and tripled such performance within the short 30 percent basket. That's pretty good. In the time period backtested, that potential equated to 14.8 percent net compound annual growth rate (CAGR).
Competitive Advantage Leads The Way
Despite a limited 60 percent active management risk exposure, the tested alternate 130/30 approaches performed well in both stand-alone and relative comparisons. Importantly, an alternate 130/30 strategy provides greater freedom to invest, and therefore caters to different managers' relative competitive advantage.
That said, some managers know that their true skills lie in picking winners on the long side, not in selecting successful short positions. After all, this has been the asset management industry's bread-and-butter business from time immemorial. For these managers, shorting with S&P 500 SDPRs or SelectSector SPDRs offers the opportunity to achieve superior returns in an alternate 130/30 format. Specifically, backtesting demonstrated the potential to generate up to a net 14 percent CAGR and 3 percent alpha using these more generalized shorting methods. In addition, these methods produced lower turnover and reduced tracking error when compared with the individual stock shorting methodology.
Finally, there will be those managers who determine the value of their corporate brand and distribution channels far exceeds that of their ability to successfully differentiate future stock performance. There is no shame in this admission; indeed, the truth could now set these managers free (and perhaps make them a lot of money). Bundling a 100 percent long passive index core (e.g., an S&P 500 SDPR ETF) with a white-labeled market-neutral hedge fund strategy can be a compelling proposition. Hedge funds would gain additional, hard-to-access avenues to deploy talent, while the alternate 130/30 manager would retain client mandates and split the additional fees with the hedge fund as client returns improve.
The Catch—Freedom
Of course, underlying all backtest results is a stock selection strategy that appears to consistently generate alpha. This is the key point, though. Freed from the investing restraints common to the long-only-style investing, and even conventional 130/30 approaches, alternate 130/30 managers have new found freedom to search for alpha in the market-neutral component of their portfolios. Given that (heavily factor-hedged) market-neutral hedge funds have generated an average long-term 9 percent gross return on a long-term historical basis, less-constrained alternate 130/30 managers now have the room they need to potentially shine as well.
Conclusion: It's The Money You Have Left At The End
The outlook for continued growth in the 130/30 market is strong. The strategies in this market finally bridge the divide between traditional, long-only management and the surging popularity of absolute return investing. There is therefore tremendous opportunity for managers of all stripes to compete in this fast-growing market.
As such, there is currently no optimal method for 130/30 implementation. The most favorable method is a function of internal competitive advantage and client risk tolerance. Accordingly, investors could be well-served to implement an alternate 130/30 strategy explicitly bundling a passive, beta-one 100 percent long core with a 30 percent long/30 percent short market-neutral equity strategy.
In the 130/30 asset class, it pays to know thyself and be creative. Managers must play to their strengths and choose the 130/30 approach that best fits their talents, preferred investing environment and the client risk tolerance.
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 130/30is 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.
|
Previous Page
