130/30
130/30? Hedge fund lite? Adding shorts is a step in the right direction away from high risk long only. But why slightly modify the performance straitjacket instead of removing it and selecting skilled managers to produce absolute returns in the best, unconstrained way they see fit? Invest in proper hedge funds. 130/30 will soon be yet another forgotten idea like portable alpha.
Adjust gross and net exposures as alpha capture conditions fluctuate. That means being 30/130 or 0/0 or 0/100 or any other split as market opportunities warrant. Investors should escape the outdated and uncompensated mania for beta. 130/30 is just another beta product and so is of NO interest to conservative investors like me. Any fund manager that won't go net short is unsuitable.
130/30 won't protect investors from a bear market. Given the 100% net long exposure, the "innovation" of adding 130/30 funds to portfolios is as useful as rearranging the Titanic's deckchairs. 130/30 is mostly about being able to put on significantly negative ideas on smaller cap equities which are precisely the stocks which have less borrowable supply, a higher lending fee and are more prone to short squeezes. The RETURN ON RISK for most 130/30 strategies is worse than 100/0 funds despite what the marketers claim. Those skilled enough to profitably short set up hedge funds NOT 130/30.
130/30 is not a hedge fund strategy and does little to help diversify a portfolio. Relative return is not absolute return. It might seem "cheaper" than a hedge fund but what are investors actually receiving? Anyone still wary of hedge funds should remember that "new" 130/30 products are considerably riskier than PROPER hedge funds. 130/30 strategies have higher volatility and WILL lose money in down markets. Short extension is about beta NOT alpha. It is time every investment mandate required fund managers to MAKE MONEY, not simply to fulfil some antiquated notion of "asset allocation". Absolute return is the way to go for a prudent fiduciary.
Why invest in 130/30 when there are better skilled strategies around with genuine alpha? Of course even in strong bull markets some stocks drop and the freedom to implement negative views on specific securities is mandatory for quality fund managers. So if an investor likes the idea of 130/30 here is what I would do:
1) Pick some good 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. Same effect but MORE skill.
2) Allocate $1.3 billion to some good LONG ONLY traditional active managers. And put $300 million with some SHORT ONLY hedge funds. Construct your own double alpha 130/30 portfolio by accessing performance-driven managers skilled in selecting either good or bad stocks.
The main argument for 130/30 is that it supposedly maximizes alpha for a given level of tracking error. But does it? There is a lot of smoke and mirrors in that contention and conveniently confuses net exposures with gross exposures. The net market exposure is 100% but the gross exposure is 160%. With 130/30 it seems the CORRECT benchmark is often more like 1.6*beta NOT 1.0*beta. It is the common trick of making beta resemble alpha through leverage.
In a real hedge fund the net exposure of longs MINUS shorts offsetting each other can be the better metric but the way many of these 1X0/X0 are being presented longs PLUS shorts looks more applicable. Alpha is the excess RISK-ADJUSTED performance NOT any return above the unleveraged index. I doubt these products will exhibit less volatility than a normal long only fund. 130/30 are taking MORE risk than an index fund so their appropriate benchmark is not the 100/0 index.
Then there is the information ratio or alpha divided by tracking error. 130/30 only maximizes the information ratio if more 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 was only generated ABOVE 32% (1.6*20) NOT 20% as they claim. In the dire panoply of misleading performance measures, tracking error targets are a sad example. Investors are basically saying to a manager "Please beat the benchmark by a tiny bit but not by a lot". Dumb.
Next time the S&P 500 drops 50% (and it will!) do you want a low "error" or a high one? The only thing obsessing with tracking error achieves is GUARANTEE that relative return managers follow the index idiots over the cliff. I think ALL fund managers should be hired for one reason alone: to make money into MORE money. If they have their own assets in the fund and are performance-driven NOT asset growth driven the interests with their clients are better aligned as is the inclination to hedge risk. Active risk is minor compared to the absolute risk of the equity market.
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 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 all in cash) if they deem necessary. Active fees pay for market judgement and risk management more than anything else. It is worth noting that in a bear market 130/30 or 1X0/X0 asset gathering products WILL have negative returns. It is STRATEGY allocation that matters not minor changes to ASSET allocation.
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 specific securities. The 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 at least a decade to develop the necessary experience in. Short positions get LARGER as you LOSE money. The worst case scenario on a long is losing 100% but better risk control is needed on shorts given unlimited upside.
And there are the ongoing issues of a short sell candidate possibly not being available, being recalled, dividend payments and short squeezes. The adjustment from simply zero weighting a stock to a negative weighting is NOT trivial; it requires many years experience of ACTUALLY shorting. Some firms that have shown limited ability to produce alpha on the long side claim they can now generate "enhanced alpha" by having the freedom to operate on the more difficult - for them - short side.
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 bull market led to low dispersion. They claim that by allowing 20-40% shorting it allows them to have a better chance of making some money. 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 swap or 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 weighting each stock in these more complex portfolios.
Why procrastinate with this intermediate step towards real absolute return 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 good hedge funds have the LOWEST portfolio tracking error.
Do the due diligence, pick some good hedge funds and let the manager decide how to vary their net and gross exposures. A truly prudent investor would not look at 130/30 when lower risk funds are available from dedicated specialists. Active extension funds have little to do with absolute return and the ONLY reason to hire any money manager, whatever the style, is for ABSOLUTE RETURN. 130/30 is another spin on relative return product lineup so why bother when YOU need absolute return?
Adjust gross and net exposures as alpha capture conditions fluctuate. That means being 30/130 or 0/0 or 0/100 or any other split as market opportunities warrant. Investors should escape the outdated and uncompensated mania for beta. 130/30 is just another beta product and so is of NO interest to conservative investors like me. Any fund manager that won't go net short is unsuitable.
130/30 won't protect investors from a bear market. Given the 100% net long exposure, the "innovation" of adding 130/30 funds to portfolios is as useful as rearranging the Titanic's deckchairs. 130/30 is mostly about being able to put on significantly negative ideas on smaller cap equities which are precisely the stocks which have less borrowable supply, a higher lending fee and are more prone to short squeezes. The RETURN ON RISK for most 130/30 strategies is worse than 100/0 funds despite what the marketers claim. Those skilled enough to profitably short set up hedge funds NOT 130/30.
130/30 is not a hedge fund strategy and does little to help diversify a portfolio. Relative return is not absolute return. It might seem "cheaper" than a hedge fund but what are investors actually receiving? Anyone still wary of hedge funds should remember that "new" 130/30 products are considerably riskier than PROPER hedge funds. 130/30 strategies have higher volatility and WILL lose money in down markets. Short extension is about beta NOT alpha. It is time every investment mandate required fund managers to MAKE MONEY, not simply to fulfil some antiquated notion of "asset allocation". Absolute return is the way to go for a prudent fiduciary.
Why invest in 130/30 when there are better skilled strategies around with genuine alpha? Of course even in strong bull markets some stocks drop and the freedom to implement negative views on specific securities is mandatory for quality fund managers. So if an investor likes the idea of 130/30 here is what I would do:
1) Pick some good 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. Same effect but MORE skill.
2) Allocate $1.3 billion to some good LONG ONLY traditional active managers. And put $300 million with some SHORT ONLY hedge funds. Construct your own double alpha 130/30 portfolio by accessing performance-driven managers skilled in selecting either good or bad stocks.
The main argument for 130/30 is that it supposedly maximizes alpha for a given level of tracking error. But does it? There is a lot of smoke and mirrors in that contention and conveniently confuses net exposures with gross exposures. The net market exposure is 100% but the gross exposure is 160%. With 130/30 it seems the CORRECT benchmark is often more like 1.6*beta NOT 1.0*beta. It is the common trick of making beta resemble alpha through leverage.
In a real hedge fund the net exposure of longs MINUS shorts offsetting each other can be the better metric but the way many of these 1X0/X0 are being presented longs PLUS shorts looks more applicable. Alpha is the excess RISK-ADJUSTED performance NOT any return above the unleveraged index. I doubt these products will exhibit less volatility than a normal long only fund. 130/30 are taking MORE risk than an index fund so their appropriate benchmark is not the 100/0 index.
Then there is the information ratio or alpha divided by tracking error. 130/30 only maximizes the information ratio if more 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 was only generated ABOVE 32% (1.6*20) NOT 20% as they claim. In the dire panoply of misleading performance measures, tracking error targets are a sad example. Investors are basically saying to a manager "Please beat the benchmark by a tiny bit but not by a lot". Dumb.
Next time the S&P 500 drops 50% (and it will!) do you want a low "error" or a high one? The only thing obsessing with tracking error achieves is GUARANTEE that relative return managers follow the index idiots over the cliff. I think ALL fund managers should be hired for one reason alone: to make money into MORE money. If they have their own assets in the fund and are performance-driven NOT asset growth driven the interests with their clients are better aligned as is the inclination to hedge risk. Active risk is minor compared to the absolute risk of the equity market.
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 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 all in cash) if they deem necessary. Active fees pay for market judgement and risk management more than anything else. It is worth noting that in a bear market 130/30 or 1X0/X0 asset gathering products WILL have negative returns. It is STRATEGY allocation that matters not minor changes to ASSET allocation.
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 specific securities. The 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 at least a decade to develop the necessary experience in. Short positions get LARGER as you LOSE money. The worst case scenario on a long is losing 100% but better risk control is needed on shorts given unlimited upside.
And there are the ongoing issues of a short sell candidate possibly not being available, being recalled, dividend payments and short squeezes. The adjustment from simply zero weighting a stock to a negative weighting is NOT trivial; it requires many years experience of ACTUALLY shorting. Some firms that have shown limited ability to produce alpha on the long side claim they can now generate "enhanced alpha" by having the freedom to operate on the more difficult - for them - short side.
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 bull market led to low dispersion. They claim that by allowing 20-40% shorting it allows them to have a better chance of making some money. 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 swap or 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 weighting each stock in these more complex portfolios.
Why procrastinate with this intermediate step towards real absolute return 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 good hedge funds have the LOWEST portfolio tracking error.
Do the due diligence, pick some good hedge funds and let the manager decide how to vary their net and gross exposures. A truly prudent investor would not look at 130/30 when lower risk funds are available from dedicated specialists. Active extension funds have little to do with absolute return and the ONLY reason to hire any money manager, whatever the style, is for ABSOLUTE RETURN. 130/30 is another spin on relative return product lineup so why bother when YOU need absolute return?
© posted by Hedge Fund on 6:44 AM
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