This is the second installment of notes from Alpha Male’s recent road trip to the Big Apple to attend Institutional Investor’s Alpha Generation Forum last week.

Ingrid Tierens of Goldman Sachs has heard just about every name there is for 130/30 strategies”.  In fact, she told an audience of portable alpha practitioners last Thursday that one of her clients is now conducting a contest to come up with the best name for this long-only/hedge fund hybrid approach to investing.

Tierens wasn’t the only speaker at this event who was particularly interested in what we at AllAboutAlpha.com call 1X0/X0 strategies.  Tony Foley, head of quantitative research at hedge fund behemoth D.E. Shaw and Charles Lemonides, CIO at ValueWorks LLC also addressed this topic.

More Efficient Than Long-Only?

Some attendees at the conference asked what was so magical about 130/30.  Why not 160/60 or 110/10?  We’ve been wondering this ourselves.

Tony Foley of D.E. Shaw explained it this way: The typical S&P500 weighting is so small (median weight: 0.097%) that avoiding a specific name altogether amounts to a de minimus bet against the stock. The manager is therefore usually unable to express her entire negative view on a name. The opportunity cost resulting from this constraint can be ameliorated by permitting a measured amount of short-selling.

But how much short-selling is enough? And how much is too much?  Foley uses the Fundamental Law of Active Management (background paper) to show that 130/30 isn’t just an arbitrary number.  He argues that the transfer coefficient (essentially the proportion of all active bets a manager is able to reflect in his portfolio) rises dramatically as the long-only constraint is relaxed (which makes intuitive sense given Foley’s first point above).  However, this pick-up in the transfer co-efficient begins to decelerate when the fund reaches the 125/25 to 150/50 range, which he called a “sweet spot”.

Beta-Neutrality vs. Dollar-Neutrality

Often 1X0/X0 strategies are described as having a 100% net exposure.  While this might be true on dollar-weighted basis, it seems to us that the beta-weighted implications are more complex.  For example, if negative views on small cap names are most in need of short-selling to be fully expressed, then one might expect the short book to contain a slightly larger number of small caps.  After all, negative views on companies with the largest S&P500 weightings can be expressed by simply removing them from the portfolio.  This begs the question; does the +30/-30 overlay have a short (beta-weighted) bias?

Furthermore, did the original long-only portfolio itself have a beta of one?  If we assume the no-short-selling portfolio was somewhat active to start with, then its beta would likely have been different than one.  And if any active portfolio can be represented by a passive portfolio and a long/short market neutral overlay (as we have argued), then the long-only core fund itself already has “1X0/X0-like” characteristics.  In the future, we’d like to see this added to the 1X0/X0 model.

1X0/X0: Better Expression of Positive Views Too

D.E. Shaw’s Foley says that the ability to express more robust negative views isn’t the only benefit of 1X0/X0.  By applying the cash generated from short-selling toward new long positions, a 1X0/X0 manager is also able to express more (and/or larger) positive views too.  Furthermore, the manager may even be able to take long positions that would have been off-limits due to certain risks - by shorting those risk factors against the new long position.

A Rose by Any Other Name?

If you’re having a deja vu right now, you’re not alone.  In the past, we have questioned whether all 1X0/X0 strategies were really just hedge funds in drag. But it seems that Ingrid Tierens has heard this skepticism before.  In rebutting this argument, she says that unlike (stereotypical) hedge funds, 1X0/X0 portfolios have all the transparency of traditional long-only funds.  Furthermore, she says, they can be more easily tracked against a benchmark, and they can also fit into the equities bucket.

We buy the transparency argument.  (Still, no one is stopping any particular hedge fund from providing the transparency of a traditional long-only fund).  But we’re not sold on the benchmark argument since the market neutral long/short portfolio embedded within a 130/30 strategy remains without an appropriate benchmark. Placing 1X0/X0 strategies into the equities bucket argument reminds us of the passing of a “Christmas Tree bill” on Capital Hill (tying a bunch of new measures onto a bill that is most likely to pass).  Still, if slotting a long-only-cum-hedge-fund into the equities bucket makes investors more comfortable, more power to ‘em.

Early Adopters

According to Goldman’s Tierens, the first wave of 130/30 strategies has been championed by quantitative long-only managers since their strategy already produces the necessary sell signals.  She calls these managers quant-amental managers (fundamental managers with a quantitative overlay).

Given the effort to position 1X0/X0 as a benign extension of a more familiar long-only strategy, it may come as no surprise that Tierens has found more interest among pension plans which have so far avoided hedge funds, rather than from endowments that have been quicker to embrace full-fledged hedge funds.  She also believes there may be retail demand for 1X0/X0 mutual funds, but admits that media attention has outstripped actual demand so far in this market segment.

At the end of the day, it seems to us that the central argument for 1X0/X0 isn’t that different from the main argument in favour of hedge funds overall: freedom of (manager) expression.

- Alpha Male