| 130/30 101 |
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| 15/04/2007 | |
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Tristram S. Lett, Managing Director and Portfolio Manager at Alpha Beta Strategies Integra Capital Corporation answers this week's 101 What is 130/30 and who developed it? While some may say that they were running strategies in the short enabled structure before Analytic Investors, I can find no one who precedes them. Harindra de Silva, Roger Clarke and Steve Sapra of Analytic Investors earn the credit for naming the process and operating the first real time portfolio. On July 1, 2002, Analytic launched its Core Plus Equity Composite (120/20) strategy. This makes perfect sense given the line of portfolio research they published based on Grinold/Kahn's "Law of Active Management" to whose logic they introduced the important notion of the transfer coefficient. They pointed out that short sales increase the alpha generating opportunity set. Recently, on the widely read blog www.allaboutalpha.com the author coined a generic form of the strategy, 1X0/X0, which I find appealing. These strategies can generally be conceived as made of two parts: an index fund or the 100 portion plus X0/X0, the market neutral portion. While non unity betas and active risk can exist in the "index" portion, I am using this contrivance for explanatory purposes. Therefore a 130/30 strategy is an index fund (100) plus 30/30, a deleveraged market neutral strategy. A fully implemented market neutral portfolio is 100/100 with its beta being cash. Equitizing its beta creates a 200/100 portfolio, which is a market neutral portfolio ported on to an equity beta. When operating 1X0/X0 portfolios, the size of the X0/X0 market neutral portion can be optimally determined by maximizing the portfolio information ratio (IR). Sorensen, Hua and Qian recently pointed out in the Winter 2006 edition of the Journal of Portfolio Management that for a given level of manager skill, the maximum IR is achieved as a function of the long only benchmark, the targeted tracking error and a number of cost considerations such as transaction and financing costs. Therefore, depending on the values for these factors, we can expect to see any number of permutations of 1X0/X0 ranging from 120/20 to 150/50. In fact, I have seen a 100/150 which is the net short version. How widely is this strategy used? What are its advantages? The strategy is not widely used among investors. Institutional investors are just learning about it. However, because of its enormous appeal, I fully expect it to be adopted quickly. The strategy lets a manager with skill to amplify his alpha-generating universe relative to his performance benchmark. A long only manager can only express his dislike of a particular stock in his benchmark by not owning it, which generally means there will be a minimal bet against the benchmark. However, if that manager can short the stock, then a .2% bet against the benchmark by not owning the stock could be expressed as 5% short against the benchmark. This is a significant underweight, which if correct, would be a newly found source of alpha. Since the short enabled portion (X0/X0) is operated as a market neutral portfolio it is a relatively benign way of increasing the potential alpha production for a portfolio. What are the challenges to implement such a strategy? Does leverage introduce a new set of risks? These strategies can only be managed by experienced quantitative firms. Because risk management is paramount, especially when a firm embarks on a program of short selling, risk must be carefully measured and managed to ensure that no directional bets creep into the portfolio. Managing a short portfolio is not the opposite of managing a long portfolio, nor is it for the faint of heart. If a short position is decreasing in value because the stock is rising, the manager must add to his short position to keep the portfolio balanced. Shorting has significant portfolio monitoring demands. Dividends must be accounted for because they have to be paid to the lender of the stock. Stock borrowing costs and the short rebate must be monitored. The performance attribution of these structures is particularly challenging. Leverage in 1X0/X0 structures is not the same as leveraging by borrowing money. It is the alpha source which is being leveraged. This is not accomplished by borrowing money per se. Since the alpha bets are balanced long and short, the volatility is generally much lower and is not the equivalent of doubling down on a stock portfolio by using broker margin. Nonetheless, new risks are introduced into the portfolio such as a short squeeze, wherein the cost of unwinding a short position can become surprisingly expensive. You have called this strategy 'hedge fund light.' Who should use this strategy? I called it that purposefully. As institutional investors are now turning their attention to hedge fund strategies, there is a great degree of trepidation in taking the first step into these uncharted waters. These investors have a significant degree of scepticism with Funds of Funds because of lack of transparency, lock ups, high fees etc. Many would like to start by introducing a relatively benign strategy that lets them get their feet wet without potential headline risk while learning how the hedging process works. 1X0/X0 strategies accomplish this. |
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Articles of the same Serie : 101 |
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