The Evolution of 130/30
IN PRINT ARCHIVE CIR Winter 2008
The Evolution of 130/30
By Margot Naudie, Managing Director, Active Fundamental Strategies, and Jean Masson, Managing Director, Head of Quantitative Research, TD Asset Management
130/30, or ‘active extension’ strategies continue to grow in popularity. Thus far, quantitative investment managers have dominated the market. However, we are now seeing the emergence of uniquely qualified fundamental managers with demonstrated security selection and short-selling skills.
Active extension strategies employ financial leverage to improve a portfolio’s risk/return profile. They do so by reducing structural limitations on long-only management. 130/30 combines elements both of long-only and of market-neutral investing. Like long-only strategies, beta remains an important component--meaning that 130/30 strategies have a place in the traditional policy mix. Like market-neutral strategies, 130/30 strategies depend on skill in short selling. Furthermore, the 130/30 concept is relatively easy to understand and apply. Finally, 130/30 strategies often provide far greater transparency and liquidity than do many hedge funds.
Quantitative and fundamental approaches have many similarities. They use the same benchmarks, access similar information, and each requires advanced risk management controls. Differentiation occurs in the process of security selection and, in turn, portfolio construction. Although the processes employed by quantitative and fundamental managers differ, both types of strategy can add value if delivered effectively
Security Selection Skill is the most important attribute an investor needs to consider in evaluating any 130/30 manager. 130/30 doesn’t create value where none exists. Rather, it extends the traditional long-only mandate to also take advantage of ‘short’ stock selection skills. If managerial skill exists, then the 130/30 structure permits greater advantage from that skill. Therefore you will want to perform due diligence on your manager’s experience in shorting and on their risk management infrastructure.
To our fundamental investment approach, this means extending the research universe to include shorts by directing our extensive team to also focus their analysis of industries and securities on areas where their view is negative. Ultimately, valuation is key to determining the best ideas for ‘longs’ and the leading candidates for ‘shorts’. In contrast, if fundamental is about depth of coverage, quantitative is about the breadth of coverage of securities in the investable universe, with a clear emphasis on data.
Shorting is a Requisite Skill. 130/30 managers must demonstrate the expertise to execute short sales as, by nature, they tend to be more volatile. A short position is an actual market exposure with a very different return profile. Most managers focus on long positions and have limited, if any, experience shorting stocks. To succeed with 130/30 strategies, you need to excel at shorting.
Quantitative managers forecast an alpha for all stocks in the allowed universe and view shorts as amplifications of underweights, taking numerous small short positions versus a few large shorts. As described above, fundamental managers view this as an extension of their research mandate to include shorts. Their share price focus demands a discipline regarding stop losses on short positions.
Managers with equity market neutral experience are perhaps most qualified in this regard – an important consideration in evaluating 130/30 managers. Also look for well-established relationships with prime brokers and experience assessing the borrowing costs explicit in short selling.
Impact on Portfolio Construction. Portfolio constraints need to reflect each underlying approach.
In the fundamental approach, a market beta of one or less is targeted. As fundamental managers focus on absolute risk as well as relative risk their strategies will typically have higher tracking error and tolerances. The portfolio will feature fewer names and somewhat broader security-level constraints.
A quantitative portfolio is constructed using optimization algorithms and risk models. This results in a large number of names, tighter individual and sector exposures, a low to moderate expected tracking error, and a tightly-controlled beta close to one.
When delivered effectively,
130/30 strategies offer investors the potential to outperform their
given benchmark with better risk-adjusted returns. Perform due diligence
on potential managers’ experience and skill, especially in
the areas of identifying and managing shorts, and in managing risk.