Here to Stay?
IN PRINT ARCHIVE CIR Winter 2007
By Tristram S. Lett, managing director, alpha beta strategies, Integra Capital Management
Institutional investors will have a profound effect on how the hedge fund industry evolves in the coming years. To date, the industry has drawn its clients from wealthy individuals who were the owners of their funds, thereby creating a direct relationship between owner and manager. Owners of funds were by no means experts in investing and often their only instruction was not to lose money. The arrival of the institutional investor has brought the fiduciary role to the management process, along with a lot of different demands, all under the umbrella of a high degree of sophisticated portfolio management techniques.
The short extension strategy is the first manifestation of this influence. The strategy allows a predefined degree of short selling balanced against an equal dollar amount of additional long positions. For example, a 30/30 portion is added to the 100 portion of any long portfolio. There are a number of ways to manage this arrangement but the common feature is that the portfolio is beta neutral to its index (a beta of 1.0).
First and foremost, the appeal of this strategy is that it is still benchmark-based, allowing it to neatly fit within a predefined bucket in every institutional investor’s guidelines. Without that, the whole effort could be a non-starter. However, the appeal to institutions does not stop there. Short extension strategies operate mostly in well-developed equity markets, thereby ensuring a high degree of liquidity and transparency. They generally do not have lock-ups and the fee levels are lower.
Another appealing factor is that they embody limited and well-controlled short selling. Short selling is complicated and is the opposite of long buying in name only. The limited exposure provides a safe laboratory for pension committees to observe how short selling works and to learn from the experience before they consider increasing exposure to hedge fund strategies.
Short extension strategies are, for the most part, operated by quantitative managers primarily because their stock-sorting processes create equal numbers of short candidates and long candidates. In addition, they have the means to control the risks in the portfolio. They also benefit managers with stock selection skill by enlarging their opportunity set to add alpha to the portfolio, without the addition of an equal amount of risk. The secret to managing short extension is tracking error. In a long-only portfolio, the only way to increase tracking error is to decrease diversification, but in a short-enabled portfolio, increasing diversification can increase tracking error. The addition of short strategies, which embody significant bets against an index, increases the tracking error while at the same time increasing diversification. The careful balancing of these two risk features, ceteris paribus, allows the potential for increasing the information ratio of the portfolio.
Short extension is a leveraged strategy, though not in the way that borrowing money to double-down on a stock position is. That potentially magnifies return in both directions, whereas, in the 130/30 context, the leverage is integral to the risk management process. While there is 60% more exposure to stocks, there can be a reduction in overall risk.
The question often arises as to what the optimal level of shorting is—120/20, 130/30, 140/40 or whatever. Indeed there is one, but it is related to tracking error, not the leverage per se. And the tracking error is related to the following: the manager’s skill; the distribution of that skill between long and short selections; the concentration of the benchmark; the size of the stocks a manager has a negative view on; the number of stocks in the buy-and-sell lists; risk characteristics of the stocks in the buy-and-sell lists; the type of alpha model the manager employs; and last, but by no means the least important, transaction costs and portfolio turnover.
In the near
future, the cute marketing monikers of 130/30 etc. will disappear
in favour of a specified level of tracking error, which is a more
appropriate way to express the strategy characteristic. But in answering
the question posed at the outset, these strategies are definitely
here to stay.