130/30 Strategies: An Alternative Source of Alpha

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by Rita Chhabra, CFA
with contributions from Charles Gabriel
JPMorgan Investment Analytics and Consulting

Plan sponsors and investors are increasingly looking for new ways to boost returns without taking on added risk. With double-digit index returns a thing of the past, funds are flowing out of large-cap U.S. equity strategies and into alternative investments, such as hedge funds and private equity. Active U.S. large-cap core equity managers saw outflows to the tune of $12.8 billion in 2006 and $1.6 billion in 2005.¹

As a result, investment managers are looking for ways to retain capital. Enter the "130/30" portfolio strategy (also known as "short-extension"). Simply stated, it involves investing 130% of the portfolio value in long positions and 30% in short positions, for a net market exposure of 100%. This approach is favored because it offers "hedge fund-like" returns without "hedge fund-like" risk levels. The split does not have to be 130/30 - it can be 120/20, 150/50, or even 200/100. The key is to have a net exposure of 100%. Many institutional investors favor this strategy because it can offer more of a controlled approach to increasing risk relative to hedge funds. An investment in a 130/30 fund does not require major changes to asset allocations or portfolio structures, just a loosening of investment guidelines and constraints.

Jacobs and Levy, in an article in The Journal of Portfolio Management, have coined this strategy as "Enhanced Active Equity." They think that "long-only portfolios are constrained in their ability to underweight securities by more than the securities' benchmark weights."² Jacobs and Levy believe that by relaxing the long-only constraint to allow short-selling, the investor has more flexibility to underweight overvalued stocks and to enhance the actively managed portfolio's ability to produce alpha. In addition, short-selling also reduces the portfolio's equity market exposure. This strategy advances the pursuit of alpha by relaxing the long-only constraint while maintaining full portfolio exposure to market return and risk. A prime broker (or custodian) makes this strategy possible to implement.

120/20 Vision
Exhibit 1 shows an enhanced active equity strategy. This strategy begins with an initial investment in an account with a prime broker, $100 in this example. The broker arranges for the investor to borrow from the stock lender the $20 worth of securities that the investor sells short. The investor then uses the $20 in proceeds from the short sales, in addition to the $100 initial investment, to purchase $120 of securities the investor wants to hold long. Long positions in the amount of $20 are used as collateral for the borrowed stocks, and are held in a stock loan account.²

Exhibit 1 - Mechanics of Enhanced Active Equity

The premise behind this strategy is that it allows the manager to overweight stocks that he believes will outperform the market, and underweight those that he believes will under-perform. As a result, the manager can add alpha from both long and short positions. If implemented correctly, one of the benefits of this strategy is added alpha relative to a long-only portfolio. Exhibit 2 illustrates the potential impact of short positions as a contributor to portfolio alpha using hypothetical portfolio weights. The manager has to be able to make the right bets, of course. If a manager cannot pick the right shorts, no amount of leverage will add alpha to his portfolio. Another potential approach within this strategy is off-setting correlations by entering into pair trades - for example, taking a long position in an automobile maker's stock and shorting its competitor's stock, if the manager believes their prices will diverge. If executed correctly, this approach can produce significant over-performance.

Exhibit 2 - Contribution to Portfolio Alpha

As mentioned earlier, the key to this strategy is maintaining 100% net exposure to the market. This is essential for a few reasons. Full market exposure allows this strategy to be similar to traditional long-only strategies in that the beta of the portfolio is 1. A portfolio with a beta of 1 is no riskier than the market portfolio, but the ability to short stocks may increase the portfolio's alpha. In addition, since this portfolio has the same market risk as the market portfolio, the allocation for this strategy can come from the traditional long-only asset class, and not fall into the 'alternatives' space. The 100% exposure also allows the manager to maintain sector weights similar to those of the benchmark.

Don't Be Blindsided
Managers of these newly popular strategies will tout the benefits, but often don't warn about the added risks and implications. Shorting, which is the borrowing of securities, represents financial leverage. If leverage is not permitted for a specific plan, plan sponsors may have to revise their investment guidelines. If not managed correctly, adding leverage may increase risk in a portfolio by amplifying the potential impact of the stock selection component of the portfolio management process. A disciplined risk management system may need to be implemented (such as a stop-loss) to mitigate some of the investment risk. In addition, an operational consideration is the increased cost of implementing this type of strategy. A 130/30 portfolio has $160 at risk for every $100 of capital. With $160 in stocks, versus $100 in stocks in a long-only portfolio, turnover can be expected to be 60% higher.² Rebalancing may also result in added costs. As prices move, the 130/30 ratio will alter; additional trading will be needed to bring the split back to its original level. Given that these portfolios have hedge fund-like characteristics in their use of leverage, investors should consult their legal and tax counsels prior to investing.

Outlook
Given the increased focus on alpha, it is safe to say that the 130/30 strategy is not a fad, but rather a potential blueprint for a new wave of funds flow. According to a 130/30 product manager for Merrill Lynch Global Markets Financing Services in New York, there could be anywhere from $500 billion to $1 trillion invested in these active extension strategies by 2010.¹ As a comparison, most experts estimate that investments in hedge funds will also reach the $1 trillion mark by 2010, but hedge funds have been around for a much longer period of time. Although the jury is still out on whether these funds will outperform in the long run, the preliminary data is in favor of this strategy versus the long-only portfolio. Relaxing investment guidelines to allow for shorting may be the way to add alpha to your portfolio without increased volatility.

¹ Pensions & Investments, May 2007
² The Journal of Portfolio Management, Spring 2006