After launching 130/30 index, S&P says best yardstick is actually a long-only index

130/30 29 Apr 2008

Back in November S&P launched its 130/30 Index, a new yardstick for short-extension funds.  To create the index they added a short extension to their existing proprietary stock-selection model and chose their words carefully when describing the result…

“The S&P 500 130/30 Strategy Index is designed to measure the performance of an investment strategy that establishes over- and underweight positions relative to the S&P 500, its parent index.”

We were skeptical – noting that 130/30 amounted to simply leveraging the alpha potential of a strategy and was not really a strategy on its own (see posting).  But we didn’t confine our skepticism to S&P.  We also raised questions about the approach taken by Credit Suisse (see posting).  We reasoned that since both indices were based on proprietary models, their performance was entirely contingent on the performance of each company’s underlying investment decisions.

While S&P stopped short of saying its index was “representative” of 130/30 funds, a published index like this is obviously meant to be used as some kind of benchmark for 130/30 managers.

But now another S&P report says the best benchmark for 130/30 managers is actually an appropriate long-only index…

“…no set of factors used in 130/30 indices can claim to capture a broad consensus in identifying stock mispricing. There also is no constraint upon 130/30 managers to use a purely quantitative investment process and there may well be more qualitatively oriented 130/30 portfolios in the future than we find today. Therefore, 130/30 indices violate one of the key principles of a good benchmark – appropriateness.”

The new S&P paper tries to distance the firm from the aforementioned model-based 130/30 indices – as articulated, for example, by Andrew Lo and Pankaj Patel in a paper last fall…

“Lo and Patel argue that traditional market indices are inappropriate benchmarks for 130/30 managers since there are leveraged long and short positions. We disagree for the following reasons:

1. The leveraged long and short positions are merely active bets – no different than the active bets taken by long only managers. While the effects of leverage may seem profound, they are no different than effects of big factor bets such as style, industry or size.

2. Leverage and shorting notwithstanding, the goal of 130/30 managers is to deliver a portfolio beta of close to 1. This beta is the market beta, which is represented by the appropriate market benchmark.

3. 130/30 managers seek to outperform market benchmarks in a risk controlled fashion. This is illustrated in Exhibit 2, which shows all institutional 130/30 managers adopting market benchmarks as their performance yardstick.”

We agree with the new S&P paper.  In fact, it makes essentially the same argument we made earlier this week – that 130/30 isn’t a whole new industry.  It’s just common sense.

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  1. curious
    April 30, 2008 at 6:31 pm

    I would love to see a completely reversed benchmark for all these alpha-oriented strategies. Rather than measuring the funds relative to the market (i.e., the “just don’t do anything”) benchmark, how about measuring the performance relative to how close the manager is from perfect achievement of it’s goals?

    For example, you could compare the long portfolio performance vs. the performance of all the stocks in the market that increase, i.e., all the opportunities that were available to make money on the long side. And you could measure the short portfolio performance vs. all the short-able stocks in the market that decreased, i.e., all the opportunities to make money on the short side. And of course measure both over a particular time period.

    This way managers would be compared against their investment strategy goal. No manager would be expected to actually achieve this perfect portfolio of longs or perfect portfolio of shorts, but managers would be measured on the basis of relative underperformance against perfection. Kind of like measuring how close they get to the bulls-eye.

    I’m oversimplifying here, but you get the idea.

    I think there would be a lot more information about manager risk-taking, strategy, and skill contained in this type of analysis than in benchmarking to traditional market indices.

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