Whether one is referring to a 1X0/X0 fund or to some other long/short variant like a market neutral fund, there is often an implicit assumption that the “net exposure” provides all the insight required into the return potential of the fund. For example, many commonly assume that 130/30 funds are “beta neutral” and therefore that the “30/30” portion will generate pure alpha. But what if that short-extension was just offsetting? To use an extreme example, if it was 30% long the S&P and 30% short the S&P, then there would be no alpha.
A research paper by Morgan Stanley (available here at AllAboutAlpha.com with free registration) reminds us that dollar-weighted exposure is not synonymous with beta-weighted net exposure. But the paper, another in a series by Marty Leibowitz and Anthony Bova, also argues that the beta-weighted net exposure doesn’t really tell us a lot about the potential information ratio (alpha/tracking error) of the fund. To gauge the potential IR of a fund, one should instead look at the ratio of “active” long positions to “active” short positions – or what Leibowitz and Bova call the “active ratio”.
The active ratio, they argue, is more descriptive of the risk/return dynamics of a fund than the more recognized dollar-weighted or beta-weighted net exposure. They say the Active Ratio can reveal how long/short funds and 130/30 funds are really just first cousins:
“By moving from active to generic positions or vice versa, a fund can adjust its activity levels to achieve a given active ratio and activity scale. With beta and active ratio flexibility, some long/short funds can be reshaped to serve as more generalized versions of a 130/30 or 150/50 active extension.”
“Active” long and short positions are defined as those that deviate from the benchmark (see posting covering a previous paper by the authors on this topic). So making a lot of active decisions when moving the long book from 100% to 130% would yield a far different active ratio depending on the activeness of the short book.
The following chart from the paper illustrates how dollar-weighted exposure, beta-weighted exposure and active exposure can all differ for the same fund:
In this example, the dollar-weighted net exposure is 60%, the beta-weighted exposure is 50% (since the longs apparently have a lower average beta than the shorts), and the active ratio is 0.67 (60%/90%).
Of course, the active ratio of a long/short fund only indicates the potential for alpha. A high active ratio means little unless you also know that the manager has a bunch of good investment ideas up his sleeve. Given the same set of alpha-producing investment ideas, two funds with very different amounts of active short and active long exposures can actually have the same information ratio – as long as the ratio of active short exposure to active long exposure is the same in both funds.
In other words, given the same set of investment ideas, a fund with active long exposure of 90% and active short exposure of 60% will produce the same information ratio as a fund with an active long exposure of 120% and an active short exposure of 80%. As long as the ratio of the two numbers remains constant, the IR remains the same. So scaling up the active long and short exposures increases alpha and tracking error in the exact proportion required to keep IR stable (as in the table below).
But while the same active ratio leads to the same IR (ceteris paribus), it doesn’t say anything about the absolute size of the alpha or the IR. That part, as usual, depends on the quality of the investment ideas. This particular paper arbitrarily assumes that the alpha of the best idea on the list is 5% and that the alphas of the remaining stocks decline linearly to 0.4% for the 50th best idea.
According to the authors, the relationship between the active ratio and the IR is governed by other factors as well. A larger number of positions requires more scraping the bottom of the barrel for investment ideas and thus leads to a lower IR for any given active ratio. Still, the IR would be the same regardless of the activity ratio chosen by the manager.
The paper dives a little deeper into the implications of this axiom, but Leibowitz and Bova tie it altogether in the following simple lesson:
“The key point is that a fund’s long and short weight may cover many different combinations of investments that can be either generic (non-alpha) or actively alpha-generating. Consequently, the standard exposure yardsticks may provide little insight about a fund’s alpha potential. The ultimate source of alphas resides in the meaningfully-sized active positions (on both the long and the short side). The cumulative effective weight of these active positions constitutes what we have termed the fund’s Activity Level. Together with the position structure, the Activity Levels determine a fund’s alpha potential, the associated tracking error, and hence the prospective information ratio.”
Download full paper here (with free registration).