130/30: View from the trading desk

130/30 08 May 2007

Too often, the non-academic dialogue surrounding emerging investment ideas is the sole domain of asset management marketing departments.  So a hat tip goes out to Bernice Miedzinski, one of the smartest and most hedge fund savvy investment consultants in Canada for giving us a heads-up on this letter by New York-based Rosenblatt Securities that discusses implementation issues on the trading desk.

The newsletter covers 130/30 investing from a trader’s perspective – making it very clear that despite all the academic rationale for the strategy, it all boils down to simple short-selling.  Trading desks, says Rosenblatt, better get ready for a lot more 1X0/X0…

“While a departure from our normal fare of market structure and exchange analysis, we thought recent developments in portfolio construction, related new product development and their relationship to trading were nevertheless relevant…”

“…we believe we are in the early innings of mandates being given for short-extension strategies. The ever-increasing demand by plan sponsors for alpha will in turn demand the removal of rigid, long-only constraints in many cases. So traders will undoubtedly come across these strategies as they trickle down from marketing/ sales, product development and portfolio managers to the trading desk.”

“Considering the continued stream of announcements as well as our own anecdotal evidence from client visits, where we can recall at least four clients (both quant and traditional, interestingly) mentioning that they either had 130/30 launches planned or were examining their merits, the list of firms managing 130/30 assets is growing longer every day.”

After treading on some familiar ground for AllAboutAlpha.com readers, Rosenblatt gets into some 1X0/X0 mechanics.  It’s not overly detailed, but it does provide a useful starting point for those interested in actually executing on all the hype.  Plus, it includes flow charts (right).  So it has to be useful, right?

But while the article is meant to be pragmatic, it does raise an interesting theoretical issue.  Rosenblatt says “The longs are established with the initial invested capital as well as the proceeds from the short sales that were deposited at the prime broker as collateral for the additional long purchases.”

Being able to redeploy capital raised via short selling like this would be a dream for any hedge fund manager since it suggests that no collateral needs to be set aside for the shorts.  In other words, one could construct a long and short book without actually having to invest anything.  Return and leverage would be infinite – or infinitely negative (in percentage terms).

In a stand-alone market neutral fund, this situation is avoided by the requirement to keep more than 100% of the short value on hand as collateral for those shorts.  So if you were to compare a real market neutral equity fund with the active overlay (30/30) portion of a 130/30 strategy, you would need to arbitrarily pick a denominator to calculate the 30/30 percent return (call it “notional collateral” if you wish).  If you chose to do this, a prime broker could probably tell you the minimum collateral needed to support that specific 30/30 portfolio.  And that minimum amount would be analogous – in “stand-alone hedge fund” terms – to a fully leveraged market neutral fund.  So in the end, the 30/30 overlay can really only be compared to a real market neutral fund with the same level of leverage.

This question illustrates why 130/30 and portable alpha are so similar on a conceptual level.  In the example above, the required capital can come from a) borrowing against the 100 or b) by re-allocating a portion of the 100 and back-filling the 100 by levering up the remaining amount.  The second of these two options is essentially a portable alpha strategy.

Despite our obsession with abstract notions of alpha and beta, questions like these are only raised by the practical implementation of 130/30.

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