Short-Extension Strategies: Risks & Opportunities

Short-Extension Strategies: Risks & Opportunities

By Tony Elavia, Ph.D., Chief Investment Officer, Equity Investors Group and Steve Landau, CFA, Managing Director and Head of Product Development, New York Life Investment Management LLC.

In their quest for more alpha, many institutional investors have considered implementing short-extension strategies, also known as long/short or 130/30 strategies, because they increase exposure to a manager’s skill. There is a common misconception that risk is increased in a short-extension strategy. This is not necessarily the case. The presentation aims to define and put into context the four sources of risks associated with these types of strategies:

Tracking Error — Many investors believe that short-extension strategies must have higher tracking error than typical long-only strategies. In fact, introducing leverage and shorting in a portfolio does not have to lead to an increase in tracking error.

Shorting — Proprietary research has shown that securities selected for shorting have twice the expected volatility of securities that are held long. This is because securities chosen for shorting tend to be companies without positive earnings or cash flows and have underperformed their peers. These factors, coupled with the potential for unlimited losses, lead to higher volatility. However, shorting risk can be reduced through diversification.

Leverage — There is a misconception that the use of leverage adds to the risk of a short-extension strategy. While short-extension strategies clearly use leverage, it does not necessarily increase tracking error or the beta of a portfolio. What it does increase, however, is the investor’s exposure to the underlying investment alpha source--the manager’s skill.

Factor Risk — Giving managers the ability to short affords them the opportunity to unlock alpha while reducing common factor risks, such as capitalization, industry, or country exposure. For small-cap securities that are overvalued, the long-only manager can only underweight them or not own them at all. The ability to take strong, active long positions and the inability to create significant negative positions through the use of shorts, creates unintended small-cap factor risk in a long-only mandate. By giving managers the ability to short securities, they are able to fully capture both positive and negative alphas in small cap securities while reducing the small cap factor risk.

Taking into account the risks noted earlier, the presentation discusses how to determine the right mix (120/20, 130/30, 140/40) of shorting and leverage by providing illustrations that compare a long-only strategy against several long/short portfolios at various levels of tracking error. In the absence of transaction and financing costs, increasing the levels of leverage and shorting will create a superior portfolio in terms of both absolute and risk adjusted returns.

Importantly, leverage and tracking error can be customized and controlled for short-extension portfolios. However, investors can’t ignore the impact of transaction and borrowing costs. The effects of leverage and shorting on net alpha are significant and will also help determine the optimal strategy.

Finally, the presentation addresses concerns about the type of manager that is best suited to manage long/short strategies. Many believe that short selling is a natural extension of a long only quantitative manager’s capability. This is because quantitative ranking methodologies can easily be applied to short selling, while fundamental managers are focused on the next buy-rated security. However, any manager’s success is based on the ability to select the appropriate stocks and effectively manage risk.

Transcontinental Media G.P.