Earlier this month, Pensions & Investments held a tri-city 130/30 dog-and-pony show in San Francisco, Chicago and New York. And this week, they released several presentations given at the event. So if you happened to have missed the show when it came through town, you might be interested in seeing the slideware available here at P&I. Below we give you our take.
John Power of Pyramis gave a succinct overview of the rationale, costs and benefits of 130/30 that also included what has probably become the most popular slide in any 130/30 presentation:
The key message, of course, is that you simply can’t bet against most names in the index in a significant manner. In our view, the difference between underweighting a 0.5% position by 0.5% and underweighting it by, say, 0.6% isn’t significant from an investment standpoint (some might argue the requisite introduction of short-selling brings with it some new operational issues).
This chart shows how 100/0, 101/01 and 130/30 are really just points on a continuum. So it’s no surprise that most institutions allocate to 130/30 from their active long-only buckets. Power presented the results of a Pyramis survey showing that public pension plans are particularly likely to view 130/30 as a form of traditional active management.
Dennis Bein, the CIO of Analytic Investors, took a slightly more, well, analytic approach to illustrating the benefits of a short extension strategy. Drawing on the Fundamental Law of Active Management and its extension to include the so-called “transfer coefficient” (pioneered by his colleagues Roger Clarke and Harindra de Silva). For those not up to speed on the F.L.A.M., the transfer coefficient essentially represents a manager’s flexibility to bake his ideas into the portfolio. No flexibility equals no transfer coefficient.
A typical active manager selecting stocks from the S&P 500 might take a position in, say, 50 to 100 names, leaving 400+ with 0% weights – even though the manager might have varying degrees of negative views on those companies. Of course, a 0% weighting on a mega-cap is a significant underweight vs. the index, while a 0% weight on a micro-cap isn’t as large a relative bet. So the manager’s 0% weights actually amount to a wide variety of different bets against the benchmark weights, and the size of each is essentially beyond his control.
But when the manager is allowed to underweight the names he truly detests to the fullest extent he wants, then his opinions can truly be transferred into the portfolio. As a result, the “transfer coefficient” rises from 0.42 to 0.68.
Bein also summarizes the variables that drive the so-called “optimal level of leverage” (i.e., the X in 1X0/X0). Aside from being a helpful summary, this list amounts to what we have proposed should be a sort of 130/30 index. Some have argued that a new 130/30 benchmark is needed while others have said that 130/30 should be benchmarked against a long-only index. We tend to fall into the long-only index camp – with one caveat. And that caveat is contained in the slide below from Bein’s presentation.
These factors have a multiplier effect on the alpha potential of a manager. In other words, if alpha exists, it will be incrementally higher in the presence of these factors. A long-only benchmark can determine if the manager is producing alpha, but an additional benchmark could be used to show if and by how much, a short extension would increase that alpha. A short extension might add no value. Or it could add significant value. So it’s almost as if there should be a secondary index measuring “the relative benefits of 130/30 ceteris paribus“. Kind of an out-there idea, we know. But we’re open to any other thoughts or comments.
Paul Calderone of Credit Suisse covered the prime brokerage angle, including “common myths about 130/30”:
- “Short Sale proceeds are used to pay for an additional $30 of long securities
- “With increased demand for shorts, securities lending could become prohibitively expensive.
- “The increase in short selling could drive the markets down.
- “The increase in shorting will be supported exclusively by institutional lenders.
- “Securities Lending (of long positions) cannot be done after converting a long-only portfolio to long-short.”
There some good slideware here for anyone looking for more in-depth analysis of 130/30. Although short-extension enthusiasts might find them quite familiar by this point.