Is an “integrated” 130/30 portfolio always better than a “combined” one?
Jun 5th, 2008 | Filed under: 130/30, Guest PostsThere seems to be a growing level of agreement that 130/30 is different than simply adding together a 100 portfolio (e.g. an ETF) and a 130/30 portfolio (e.g. a market neutral fund). Some practitioners have pointed to the untrimness of being long and short some of the same stocks (e.g. Jacobs & Levy - see related posting). But others such as First Quadrant’s Jia Ye have argued that adding a short-extension will not always be optimal even for the alpha-producing manager due to the potential volatility of the information coefficient (see posting).
Today, guest contributor Srikanth Iyer, Senior VP and Senior Portfolio Manager, Global Systematic Strategies at Guardian Capital LP puts these two ideas together by exploring whether a so-called integrated 130/30 portfolio is always optimal.
130/30 “Combined” vs. “Integrated”: The Tail Wagging the Dog
Special to AllAboutAlpha.com by: Srikanth Iyer, SVP, Guardian Capital LP
The rapidly evolving landscape of 130/30 has seen many investment concepts used in interchangeable and often inappropriate ways. As more players enter this space, it’s likely that we will see a further dilution of these core concepts. The debate between a combined and integrated approach to active extension strategies is a classic example of how important concepts relating to return and risk are being bypassed to placate existing investment approaches. The demands of business development add further confusion to the discussion about 130/30 strategies.
An integrated 130/30 portfolio is created using a mean-variance optimizer that uses the correlations between individual long and short securities to achieve an optimal mix for a given risk budget or ex ante tracking error. In contrast, a combined 130/30 portfolio combines an existing mean-variance optimized long only portfolio with an integrated 30 long/30 short portfolio - effectively, combining a long only beta adjusted return with a zero-beta market neutral return.
The chart below from a recent report by Credit Suisse illustrates the subtle differences between these two approaches. (left=integrated, right=combined)
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The act of cash in a portfolio is on our end seen as a substitute for a larger error term than normally exhibited by our models. Cash is useflu only under circumstances when the model is not able to expalin a significant component of stochastic behaviour. By defenition a spike in the error term menas we are not seeing any ideas. Purely on a defensive basis cash inclusion is a value added component used as a substitute for the error term. One can minimize cash from the equation if the “n” or number of stocks in a portfolio can be increased as a result of a spike inthe error term. This is counter intuitve to the extent that it increses the systemic risk inthe portfolio and hence offers no tangible alpha, however the goal in this case is to reduce the tranfer coeffecient during times of IC volatility. We use cash if we do see these conditions emerge as in January 2008 or May 2006.