Since 130/30 or “short-extension” funds entered the investment lexicon over 3 years ago, it has generated considerable debate. While industry commentators derided the strategy in the media, academics remained steadfast in their belief that short extension strategies have merit.
So what gives? What is it in the academic literature that could support the existence of value in a strategy whose brief history seems to provide empirical evidence to the contrary? Critics say that short extension strategies face some operational headwinds that long-only funds do not – that shorting is not simply the “reverse of long investing”.
The truth is that 130/30 funds are both academically sound and operationally-challenged. An article by Morningstar published today provides a relatively dispassionate overview of these factors that stand in stark contrast to the typical critique of the 130/30 concept based solely on performance. In it, Morningstar’s Nadia Papagiannis highlights several unique challenges faced by 130/30 managers:
- Negative Carry: Short-selling is not as efficient and long investing. It requires additional business processes such as locating a borrow and executing the various legs of a short-sale. As a result, there is a necessary drag that presents itself as a negative spread between the PB’s lending rate and the interest earned on cash balances used as collateral.
- Trading Costs: While not a cost of shorting per se, Papagiannis points out short positions tend to be more short term in nature, meaning that shorts turnover more than longs. (We blame that on the catalyst-driven nature of short ideas, though, not the oft-cited risk of “unlimited loss”).
We do not count the rebalancing costs of sticking exactly to 130/30 (and not, say, 128/28) since this is not a necessary element of a short-extension strategy. We also don’t count the unique skills or experience required to short-sell, since this is a factor relating to the management firm, not to the strategy itself (unless those skills will always cost more). Further, we’re not counting the cost of paying dividends on shorts (the opposite of receiving them on longs) since the net dividend carry of the short extension (30/30) is a factor that lies outside of the 130/30 strategy itself.
In any case, negative carry and trading costs are unavoidable and real. In part due to these costs, Papagiannis shows that 130/30 versions of popular US mutual funds has underperformed their long-only sister funds. (Regular readers will note that this is similar to the back-testing conducted by Gordon Johnson in early 2008 – see post.)
We’ve removed the fund names to protect the innocent, replaced them with the 130/30 fund’s launch date, and created this chart with the data in the Papagiannis’ article. Returns for both twins are since the 130/30 fund’s inception date.
The median outperformance of the 130/30 versions is about -40 bps. Since 130/30 funds are assumed to have a 1.0 beta, this suggests that the short extensions have a negative alpha. But this may not be accurate for two reasons: 1) the number of months is so small that the Beta of 1.0 may not be accurate and 2) The Beta may not even be 1.0.
In fact, Papagiannis shows that the average Beta of a sample of large 130/30 funds now ranges from 0.87 to 1.13. The funds with a 1.13 beta actually outperformed its long-only sister fund – suggesting that it actually did even better than it first appears. In the flip side, some under performing funds had betas of less than one underperformed the market, suggesting even worst value-added that it initially appears.
Despite all the criticism of 130/30 fund returns, the removal of the major outlier above (the second fund), bumps the median out performance into positive territory. So if shorting really does come with new operational costs, then the managers of these funds may be adding enough alpha to at least cover those costs.
But this is splitting hairs. It’s still far too early to reach any conclusions about 130/30 based on a median out performance that hovers around 0%. If we are to drawn any conclusion about 130/30 funds, it’s that their alpha, like those of their active management predecessors adds up to zero.
Investors in active long-only funds have ignored this reality and have instead attempted to pick their own alpha-producing managers for years. Short extension funds are simply an extension of this philosophy.
In conclusion, Papagiannis reconciles the views of proponents and critics of short-extensions:
“While we believe that 130/30 or 120/20 funds are largely marketing gimmicks, the idea of a long portfolio, combined with a short extension to emphasize a manager’s best and worst picks, is a good one. But the key to success is a dynamic short-extension, rather than sticking to a static 130/30 or 120/20 model, which has no economic rationale.”