120-20 reaches mythical proportions?

130/30 14 Oct 2007

“Myth: A popular belief or story that has become associated with a person, institution, or occurrence, especially one considered to illustrate a cultural ideal.”
American Heritage Dictionary)

CFAs out there are undoubtedly familiar with the names “Jacobs” and “Levy”.  The duo literally wrote the book on equity management.  And in the 1980s, they authored several articles for the likes of the Financial Analysts Journal and the Journal of Portfolio Management which contained empirical evidence that strongly questioned efficient markets (e.g. calendar anomalies, value factors).

Perhaps as a result of their belief that markets were inefficient, the two have also had a soft-spot for long/short investing.  In fact, their book, Market Neutral Investing, has been part of the reading list for the Chartered Alternative Investment Analyst (CAIA) designation.

In 1996, before hedge funds became the cat’s meow, they wrote an article on what they viewed as prevailing “myths” about long/short investing (““).  This was a seminal article in the then nascent field of hedge fund investing even if the industry was likely too embryonic at the time to give rise to misconceptions so widespread that they truly qualified as “mythical”.  (A great literary device nonetheless).

That same literary device was redeployed recently in an article published in the summer (and recently provided for free on the CFA website) called “20 “.  Once again, the pair has produced a comprehensive easy-to-read review of the state of an emerging industry.

To adhere to “fair use” copyright guidelines, we won’t list all 20 myths here.  We encourage you to read the article itself.  But listed below are our top 5 favorites:

“Myth 7. Enhanced active equity portfolios are inherently much more risky than long-only portfolios because they contain short positions.”

“Myth 3. A 120–20 equity portfolio can be constructed by combining two portfolios – a long-only 100–0 portfolio and a 20–20 long–short portfolio.”

“Myth 8. Enhanced active equity strategies provide investors a free lunch.”

“Myth 15. The short selling in enhanced active equity strategies will drive equity market levels down.”

“Myth 13. Enhanced active equity strategies must provide cash collateral for the short positions, including meeting daily marks to market, which complicates trading and requires a cash buffer that can reduce returns.”

We agree with all of the myths.  However, we find a few of them to be somewhat contrived.  In other words, some of Jacobs & Levy’s arguments don’t really seem to qualify as “common myths” and may better be described simply as good points re-phrased as myths – sort of like the game show Jeopardy where contestants’ answers need to be stated in the form of a question.

We have no doubt that most of these concerns have come up in Jacobs & Levy’s client pitches – and Jacobs himself says he often hears them from the industry itself.  But are they really “common myths”?

For example, Myth #17 “Converting long-only mandates to enhanced active equity has no effect on a manager’s asset capacity” sounds a little more like a recurring point of discussion during a client pitch rather than it does a common, widely-circulating misconception. (In a CFA Institute Webcast, Jacobs invokes this “myth” in support of 120/20 fees – suggesting it may be a counter-argument to fee concerns, rather than a top-of-mind “popular belief”.)

Here are 2 others that seem to us not to really qualify as “myths”:

“Myth 1. Long-only portfolios can already underweight securities by holding them at less than their benchmark weights, so short selling offers little incremental advantage.”

– An excellent point.  But wouldn’t anyone who understands this “myth” surely already know that most benchmark weights aren’t actually large enough to give underweighting much of an impact?

“Myth 2. Constraints on short selling do not affect the portfolio manager’s ability to overweight attractive securities.”

– While it’s certainly true that you can use the short proceeds to go long, is this myth – as phrased – really a “popular belief”? Naturally, they do affect a manager’s ability to overweight attractive securities – in fact, they make such overweights possible.

In the end, we think the “20 myths” can be grouped into 6 broad categories:

  1. 120-20 is not just a “hedge fund lite” (myths 3, 5, 6, 18, 19, 20)
  2. Short-selling isn’t that helpful (myths 1, 2, 4)
  3. Short-selling is evil (myths 7, 14, 15)
  4. Leverage is evil (myths 9, 10)
  5. It’s all too costly (myths 11, 12, 13, 16)
  6. 120-20 is a silver bullet (myth 8, 17)

In our (much more limited) opinion, these are the real myths (a.k.a. the “popular beliefs or stories”) surrounding 1X0/X0 investing.

But regardless of our editorial viewpoint, the article contains some great arguments and is a must read for anyone who is about to pitch or to adopt a 1X0/X0 strategy.

And while you’re at it, listen to Bruce Jacobs himself discuss the paper in this free 45-minute webcast from the CFA Institute recorded a few weeks ago.  In it, Jacobs covers a few of the bigger myths and answers questions like:

  • Why is 120/20 so popular now? (A: regulatory changes allowing short proceeds to be spent on more longs, low market volatility, advancements in prime brokerage technology, and a general low return environment).
  • What happens if you have no skill? (A: you shouldn’t be running any active money, let alone 130/30 or 120/20).
  • What other skills are required? (A: good insights, good risk control to keep beta at 1.0, shorting experience).
  • What is the optimal level of shorting? (A: marginal benefits decline while costs keep rising and a client’s residual risk tolerance will determine where to stop).
  • How have they performed? (A: anecdotally well over the long term, recently poor – but not as bad as hedge funds).
  • What if markets don’t allow short-selling? (A: use CFDs or swaps instead).
  • What are the fees? (A: higher since they use more of a manager’s capacity, closer to regular institutional fees than hedge fund fees).
  • How does 120/20 impact diversification? (A: unlike long-only, active risk with 120/20 actually adds to diversification).
  • How do you evaluate a 120/20 manager? (A: be cautious about simulations since applicable stock-borrows may not have been available at certain points in the past)
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  1. David Merkel
    October 16, 2007 at 1:23 am

    Call me a fuddy-duddy. Few managers have the requisite skill to do well at long only, and 120/20 is if anything more difficult, particularly in an era where the borrow is often crowded.

    Let’s see some performance comparisons, and get this out of theory.

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