by Veryan Allen
26.5.07
130/30? Pseudo hedge fund or passing fad? 130/30 is not a hedge fund strategy, not a portfolio diversifier and not even a new thing. It is unfortunate to see some investors sold on this "innovation" but it is even sadder to observe firms that have shown limited ability to generate alpha on the long side suddenly think they can generate alpha on the short side. Of course doing some shorting is a step in the right direction away from long only equity investment but why slightly adjust the performance straitjacket instead of removing it entirely and picking skilled managers to produce alpha in the SAFEST way they see fit? 130/30 might "look" cheaper than a hedge fund but what are investors REALLY getting? Is the "higher" information ratio really higher?
Constraints impede risk-adjusted performance. Good hedge funds work because of flexibility in dynamically altering their market exposures. Simply relaxing the no-shorting constraint a little doesn't help much and neither does this active short extension or enhanced indexing nonsense. A manager should be allowed to be positioned 190/10, 100/100 or 10/190 and sometimes 0/0 (ie all in cash) if they deem necessary. Active fees are to pay for market judgement and risk management more than anything else. It is worth noting that in a bear market these 130/30 or 1X0/X0 asset gathering products will likely STILL lose money. It is STRATEGY allocation that matters not minor changes to ASSET allocation.
130/30 is really a dispersion or equity correlation trade. It has been difficult for weaker traditional quant long only managers to produce alpha because the current bull market has led to low dispersion. They claim that by allowing 20-40% shorting it allows them to have a better chance of making some money in excess of the market beta. But why not allocate instead to hedge funds that have traded dispersion and correlation for many years? Why not use put options to implement the short side and avoid the complications of shorting? Why not equitize a 30/30 market neutral fund by overlaying an index future yourself? Dispersion also varies; in a bear market correlation between stocks tends to be much lower. There are also ongoing issues of position sizing and how to weight each stock in these more complex portfolios.
The main argument for 130/30 is that it maximizes alpha for a given level of tracking error. But there is a lot of smoke and mirrors in this contention and they are often conveniently confusing net exposures with gross exposures. If your universe is a list of 160 equities and you select 130 stocks to buy and 30 to short, you are implying your ability to make alpha on both sides. The net market exposure may be 100% but the gross exposure is 160%. With these products it seems that their CORRECT benchmark is often 1.6*beta NOT 1.0*beta. It is the common trick of making beta look like alpha through leverage. In a "market neutral" or hedged fund the net exposure, longs-shorts offsetting each other, can be the better metric but the way these 1X0/X0 are being pushed longs+shorts looks more applicable. Alpha is the excess RISK-ADJUSTED returns, NOT any return above the unleveraged index. I doubt most of these products will exhibit the much touted equal or lower volatility than a normal long only fund.
Then there is the almighty Information Ratio or alpha divided by tracking error. 130/30 only maximizes the information ratio if EXTRA alpha REALLY was generated as a result of that increased market exposure without a similar trade off in volatility. If the S&P 500 goes up 20%, the chances are alpha only kicks in ABOVE 32% (1.6*20) NOT above 20% as they claim. In the dire panoply of misleading performance benchmarks, tracking error targets are the silliest. Investors are effectively saying to a manager "Please beat the index by a tiny bit, but if you exceed it by a lot you'll be fired". Next time the S&P drops 50% (and it will, sometime!) do you really want a low "error" or a high one. The only thing focusing on tracking error does is guarantee active managers follow the indexers over the cliff. I think ALL managers should be hired for one reason alone: to make money no matter what. If they have their own money in the fund and are performance driven NOT asset driven the interests with their clients are much better aligned as is the inclination to properly hedge and manage risk. Active risk is irrelevant compared to absolute risk.
130/30 products don't do much to diversify a portfolio. The STRATEGY is the same as 100/0; long biased stock picking but just with wider bounds on overweighting and underweighting a particular holding. A core argument is that it allows more meaningful underweighting of the smaller cap index components. But short selling also opens up issues that a shorting neophyte takes time to develop experience in. Short positions get LARGER as you LOSE money. The worst case scenario on a long is losing 100% but much better risk control is needed on shorts. And there are the ongoing issues of a short candidate possibly not being available, dividends and short squeezes. The adjustment from just zero weighting a stock to a negative weighting is not so simple; it requires many years experience of ACTUALLY shorting. Why waste time on quantitative long only managers when an investor can access higher levels of skill and experience with real, dedicated hedge funds?
130/30 is a predictable response of the asset gathering incumbents trying to protect their market share against better, more skillful products that produce genuine, high alpha. Of course even in the strongest bull markets some stocks still go down and the freedom to implement negative views on stocks is essential. So if an investor really likes the sound of 130/30 here is what I would do:
1) Pick some proper equity long short hedge funds and put them in the equities allocation NOT the alternatives bucket. Hedge funds are NOT an asset class. Most equity hedge funds are long biased anyway and provide enough exposure data to construct an overall 130/30 portfolio split.
2) Place $1.3 billion with a selection of good, specialist long only traditional funds. And $300 million with a selection of good, specialist short only hedge funds. Construct your own double alpha 130/30 portfolio by accessing proven, FOCUSED skills in selecting good and bad stocks.
3) Put on watch all existing mandates across asset classes with any firm that pitches the wonders of 130/30. It is NOT the future of equity investing and there is plenty of capacity in real hedge funds. Simply buy an options strangle on the S&P if you want a little more index based equity portfolio leverage.
Why procrastinate with this intermediate step towards unconstrained, risk managed mandates? Why put money in a non-diversifying, limited track record product where alpha is calculated on the net exposure while the risk (and fees!) are more dependent on the gross exposure? The ONLY tracking error that ACTUALLY matters is not to an arbitrary stock index but to the assumed actuarial return. In terms of matching assets to liabilities hedge funds have by far the LOWEST tracking error.
Bottom line: do the due diligence, pick some good funds, write the check and let the manager decide how to vary their own fund's net and gross exposures. A truly prudent man would never look at 130/30 when better, lower risk financial products are now available from dedicated specialists. Should a fiduciary choose a boutique portfolio manager whose vocation to is to achieve performance no matter what or instead select yet another generic "product" from the financial supermarkets that WILL lose money when the markets implode? These short extension funds have nothing to do with absolute return and the ONLY reason to hire a money manager whatever the strategy is ABSOLUTE RETURN.
Constraints impede risk-adjusted performance. Good hedge funds work because of flexibility in dynamically altering their market exposures. Simply relaxing the no-shorting constraint a little doesn't help much and neither does this active short extension or enhanced indexing nonsense. A manager should be allowed to be positioned 190/10, 100/100 or 10/190 and sometimes 0/0 (ie all in cash) if they deem necessary. Active fees are to pay for market judgement and risk management more than anything else. It is worth noting that in a bear market these 130/30 or 1X0/X0 asset gathering products will likely STILL lose money. It is STRATEGY allocation that matters not minor changes to ASSET allocation.
130/30 is really a dispersion or equity correlation trade. It has been difficult for weaker traditional quant long only managers to produce alpha because the current bull market has led to low dispersion. They claim that by allowing 20-40% shorting it allows them to have a better chance of making some money in excess of the market beta. But why not allocate instead to hedge funds that have traded dispersion and correlation for many years? Why not use put options to implement the short side and avoid the complications of shorting? Why not equitize a 30/30 market neutral fund by overlaying an index future yourself? Dispersion also varies; in a bear market correlation between stocks tends to be much lower. There are also ongoing issues of position sizing and how to weight each stock in these more complex portfolios.
The main argument for 130/30 is that it maximizes alpha for a given level of tracking error. But there is a lot of smoke and mirrors in this contention and they are often conveniently confusing net exposures with gross exposures. If your universe is a list of 160 equities and you select 130 stocks to buy and 30 to short, you are implying your ability to make alpha on both sides. The net market exposure may be 100% but the gross exposure is 160%. With these products it seems that their CORRECT benchmark is often 1.6*beta NOT 1.0*beta. It is the common trick of making beta look like alpha through leverage. In a "market neutral" or hedged fund the net exposure, longs-shorts offsetting each other, can be the better metric but the way these 1X0/X0 are being pushed longs+shorts looks more applicable. Alpha is the excess RISK-ADJUSTED returns, NOT any return above the unleveraged index. I doubt most of these products will exhibit the much touted equal or lower volatility than a normal long only fund.
Then there is the almighty Information Ratio or alpha divided by tracking error. 130/30 only maximizes the information ratio if EXTRA alpha REALLY was generated as a result of that increased market exposure without a similar trade off in volatility. If the S&P 500 goes up 20%, the chances are alpha only kicks in ABOVE 32% (1.6*20) NOT above 20% as they claim. In the dire panoply of misleading performance benchmarks, tracking error targets are the silliest. Investors are effectively saying to a manager "Please beat the index by a tiny bit, but if you exceed it by a lot you'll be fired". Next time the S&P drops 50% (and it will, sometime!) do you really want a low "error" or a high one. The only thing focusing on tracking error does is guarantee active managers follow the indexers over the cliff. I think ALL managers should be hired for one reason alone: to make money no matter what. If they have their own money in the fund and are performance driven NOT asset driven the interests with their clients are much better aligned as is the inclination to properly hedge and manage risk. Active risk is irrelevant compared to absolute risk.
130/30 products don't do much to diversify a portfolio. The STRATEGY is the same as 100/0; long biased stock picking but just with wider bounds on overweighting and underweighting a particular holding. A core argument is that it allows more meaningful underweighting of the smaller cap index components. But short selling also opens up issues that a shorting neophyte takes time to develop experience in. Short positions get LARGER as you LOSE money. The worst case scenario on a long is losing 100% but much better risk control is needed on shorts. And there are the ongoing issues of a short candidate possibly not being available, dividends and short squeezes. The adjustment from just zero weighting a stock to a negative weighting is not so simple; it requires many years experience of ACTUALLY shorting. Why waste time on quantitative long only managers when an investor can access higher levels of skill and experience with real, dedicated hedge funds?
130/30 is a predictable response of the asset gathering incumbents trying to protect their market share against better, more skillful products that produce genuine, high alpha. Of course even in the strongest bull markets some stocks still go down and the freedom to implement negative views on stocks is essential. So if an investor really likes the sound of 130/30 here is what I would do:
1) Pick some proper equity long short hedge funds and put them in the equities allocation NOT the alternatives bucket. Hedge funds are NOT an asset class. Most equity hedge funds are long biased anyway and provide enough exposure data to construct an overall 130/30 portfolio split.
2) Place $1.3 billion with a selection of good, specialist long only traditional funds. And $300 million with a selection of good, specialist short only hedge funds. Construct your own double alpha 130/30 portfolio by accessing proven, FOCUSED skills in selecting good and bad stocks.
3) Put on watch all existing mandates across asset classes with any firm that pitches the wonders of 130/30. It is NOT the future of equity investing and there is plenty of capacity in real hedge funds. Simply buy an options strangle on the S&P if you want a little more index based equity portfolio leverage.
Why procrastinate with this intermediate step towards unconstrained, risk managed mandates? Why put money in a non-diversifying, limited track record product where alpha is calculated on the net exposure while the risk (and fees!) are more dependent on the gross exposure? The ONLY tracking error that ACTUALLY matters is not to an arbitrary stock index but to the assumed actuarial return. In terms of matching assets to liabilities hedge funds have by far the LOWEST tracking error.
Bottom line: do the due diligence, pick some good funds, write the check and let the manager decide how to vary their own fund's net and gross exposures. A truly prudent man would never look at 130/30 when better, lower risk financial products are now available from dedicated specialists. Should a fiduciary choose a boutique portfolio manager whose vocation to is to achieve performance no matter what or instead select yet another generic "product" from the financial supermarkets that WILL lose money when the markets implode? These short extension funds have nothing to do with absolute return and the ONLY reason to hire a money manager whatever the strategy is ABSOLUTE RETURN.
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© posted by Veryan Allen at 26.5.07
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