(Bilingual) Reader Mail: Many managers “poorly equipped” for 130/30

130/30 15 Oct 2007

Doug Cote of start-up manager Schooner Investment Management writes that many 1X0/X0 managers fail to measure whether they are adding excess beta risk.  In response to our musings about translating AllAboutAlpha.com into Mandarin, Cote kindly sends along a Chinese version of his comments. 

Guest posting by: Douglas Cote, Schooner Investment Management  

The 130/30 strategy is a prudent method of employing leverage to a portfolio, contrary to some believing 130/30 funds to be a fad. This strategy will be a significant benefit to investors if implemented and managed properly. 

Clients to this day exude awe of portfolio managers that know how to sell short a stock or group of stocks (I suppose it’s because they can charge higher fees). Quantitative investment managers are uniquely trained to understand shorting mechanics because the models they build are based on the expectation of a symmetric distribution of returns both positive and negative.

1X0/X0 or in this case 130/30 funds are best implemented by treating the strategy as component portfolios or as a long portfolio and a market neutral portfolio.  This will have the salutary impact of identifying the component alphas and component risk.  As a client and an investment manager I want to know if my value added is coming from the long portfolio or the portable alpha strategy or in this case the market neutral strategy.  In essence we have a double alpha portfolio with a beta matching constructing the portfolio.

The error the industry is making with 130/30 funds in not clearly identifying whether this additional equity exposure is creating excessive beta risk to the fund.  This is accomplished by measuring ex-post the volatility of the long-short spread and managed properly by monitoring the ex-ante or expected volatility of the long-short spread.

Another mistake is the inability to measure the alpha long-short spread,  positive or negative, is the point of implementing this strategy in the first place.  It is also important to fully reflect the costs associated with this leveraged strategy.  The client must require that the return fully reflects all expenses associated with employing leverage.  This includes financing of leverage in the margin account, the benefit of the short rebate, costs in borrowing and lending securities to name a few.

130/30 or generically 1X0/X0 funds are a profound innovation in the investment management business requiring very experienced investment managers to manage the layers of risk and return inherent in the strategy.  Many investment managers are poorly equipped to manage this complex innovative product.  The future of money management is to clearly segregate alpha from risk for both investor reporting, performance attribution, and portfolio management.

– D. Cote, October 11, 2007

Link to PDF of following translation

(Note: The opinions expressed in this posting are those of the author and not necessarily those of AllAboutAlpha.com.  Chinese translation was provided directly by the author.  As a result, AllAboutAlpha.com accepts no responsibility for any inaccuracies in said translation.  However, AllAboutAlpha.com does think said translation is a good idea.)

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