We talk a lot about the theory behind 1X0/X0 strategies. But given the nascence of this sub-sector, it has been difficult to come up with any real-life examples about which to write. Today, however, we welcome guest contributor and 130/30 investor, Steve Cochrane, the Chief Investment Officer of the North Dakota State Investment Board (NDSIB). With over 26 years of institutional investment experience Steve is responsible for the administration of the agency as well as overseeing a $5.4 billion diversified investment portfolio. The NDSIB was selected as a nominee for Money Management Letter’s 2007 Savviest Public Plan of the Year and is a speaker at Terrapinn’s upcoming 130/30 conference in Santa Monica.
130/30: How it works for North Dakota State Retirement Scheme
Special to AllAboutAlpha.com by: Steve Cochrane, Chief Investment Officer, North Dakota State Investment Board
After twenty years in the institutional investment management business, I came to a monumental realization that what I had learned in business school is true: large cap securities that are actively traded in major financial markets are most likely efficiently priced. It has now been eight years since that awakening.
The efficient markets hypothesis (EMH) was originally developed in the late 1960’s. It states that market prices should reflect all information known about a security. After forty-five years of research and testing, most agree that this hypothesis is increasingly correct as capitalization and liquidity increase. When it comes to the Large Cap Domestic Equity asset class in the United States, theory converges with reality.
I arrived in North Dakota to assume the CIO role in January of 1997. Awaiting me was a US$2 billion pension fund with an array of active managers who were benchmarked against the S&P500 index of large cap stocks, as well as S&P500 style benchmarks. While some were growth oriented and others pursued value and yield investing, they all had one thing in common: underperformance relative to benchmark.
The pension fund in North Dakota is set up with a long-term strategic allocation based on actuarial asset / liability studies. The studies contain a long term projection of expected return and risk based on benchmark inputs. It is the job of the State Investment Board to implement the investment of these asset classes. Each of the ten asset classes has a standard benchmark. So if we can outperform the benchmark of each asset class, we can exceed the policy mix for the fund and thereby generate total plan “alpha”.
In the year 2000, North Dakota moved to exit active management of Large Cap US Equity entirely. The degree of manager activity was defined by tracking error (TE) relative to the S&P500. If a manager displayed a TE of 6% or more since inception, they were considered to be “fully active” and therefore no longer a fit for our portfolio. Based on this analysis, all of the managers in this asset class were terminated – not specifically because of the performance issue, but simply due to the volatility of excess (or negative excess) returns.
The only exception was an exposure to an S&P500 index fund, with TE close to 0%. This mandate represented 10% of the 30% fund allocation to Large Cap Domestic Equity. (Ultimately, this index exposure was revised to a 130/30 enhanced index approach, using the same investment manager.)
The asset class was reconfigured to a “stratified” strategic exposure of three risk tranches defined by TE. The index fund would have a target TE of 0%. Moving up the spectrum, “enhanced” managers would have expected TE of 1-3%, and “structured” strategies would have expected TE of 3-5%. So the question became, “what investment styles can be expected to achieve these targets?” This led us to our first use of portable alpha, quantitative investment models and ultimately to 130/30.
Following years of successful use of quantitative models, it was not a huge leap for the Investment Board to consider a 130/30 strategy applied to an enhanced portfolio. The initial due diligence involved analysis of the index manager’s basic enhanced index fund. The manager had a long-term positive track record which resulted from a quantitative ranking system of S&P 500 stocks. Maximum over- and under-weight positions were set at 50 basis points. Because of the relative weights of the index stocks, many of the under-weights were limited to much less than 50 basis points.
The application of a 130/30 strategy was viewed to have the capacity to “unlock” the full informational content of this enhanced portfolio. The index fund was transitioned to 130/30 in May of 2006. Results were positive relative to index through the third quarter of 2007 on a cumulative basis. Due to the dislocations in the marketplace which broadly affected quantitative managers during the second half of 2007, this portfolio suffered. The suffering was, of course, amplified by the active extension strategy. Since October of 2007, cumulative results have been negative relative to index.
Time to abandon ship? Not at all. The Investment Board feels that the strategy remains valid and that the application of a 130/30 approach fully expand a manager’s ability to recognize and exploit the relative attractiveness of stocks. I would expect that we will continue to consider such strategies and that the future for 130/30 (and its kind) is quite robust. Stay tuned!
– S. Cochrane, February 22, 2008
The opinions expressed in this guest posting are those of the author and not necessarily those of AllAboutAlpha.com.