The 130/30 strategy—which utilizes leverage by underweighting (shorting) poor performing stocks and overweighting undervalued stocks—is not new to institutional investors. Hedge funds have used it for years. However, in the aftermath of the global financial crisis, the lack of transparency inherent in hedge funds has made the strategy unpalatable for many institutional investors, who have gone elsewhere in search of alpha.
According to the quarterly Standard & Poor’s Index Versus Active (SPIVA) scorecard, only 5.9% of Canadian equity managers have managed to outperform their index benchmark on a five year return basis. However, Srikant Dash, head of global research & design at Standard & Poor’s Index Services says you can enhance an index’s methodology to seek potentially better returns within an index-like framework.
Horizons AlphaPro’s recent launch of its S&P/TSX 60 130/30 ETF attempts to deliver, before all fees and expenses, the performance of the S&P/TSX 60 130/30 Strategy Index.
Triumph of hope over reality
Dash is applying S&P’s 130/30 methodology to the S&P/TSX 60 Index to create what he calls a “strategy based index”. The S&P/TSX 60 130/30 Strategy Index will overweight and underweight certain stocks relative to the S&P/TSX 60 Index using a combination of both quantitative and qualitative measures.
“SPIVA shows active managers underperform, however, when you look at actual investor dollars in indexes versus active managers, index-tracking ETFs account for less than 5% of invested dollars,” says Dash. “I call this the triumph of hope over reality. People don’t want to settle for average returns, which they perceive as represented by the index.”
Dash is looking for a way to create an “enhanced beta” product that will offer the prospect of outperformance versus the index, with a risk profile very similar to the index. The S&P/TSX 60 130/30 Strategy Index methodology was created to allow for overweight and underweight positions relative to the S&P/TSX 60 Index.
AlphaPro president Ken McCord says the S&P/TSX 60 130/30 ETF is such a product.
McCord points out that the ETF offers an alternative to traditional index-tracking ETFs for investors that already have heavy long-only exposure to the S&P/TSX 60 Index, and is a cost-efficient way to get access to a 130/30 investment strategy.
Dash says the 130/30 index offers transparency, diversification, and the potential for risk-controlled outperformance. It is rebalanced quarterly to capture any changes to the constituents or the outlook of the stocks in the S&P/TSX 60 Index. And it will include both fundamental and quantitative analysis to determine the underweight and overweight positions.
Same same, but different
So is it right for pension plans? According to Zainul Ali, head of Canadian Research with Towers Watson, it depends on the client’s familiarity of the 130/30 strategy.
“The first thing an investor needs to get comfortable with is the actual mechanics of how a 130/30 strategy works,” he says. “If you’re not comfortable with the whole idea of shorting stocks then it’s not something you should be looking at.”
The only difference between AlphaPro’s 130/30 strategy and that of a traditional hedge fund, he explains, is that hedge funds don’t have a 30% limit on shorting.
“They can go higher than that, up to a net short position. A lot of folks, including pension plan investors, want to put a limit on the shorting. At the end of the day, this is leverage.”
Still, one might wonder why an investor wouldn’t just go to a hedge fund and hammer out a deal regarding risk controls and leverage instead of trying out a new, relatively unproven product.
“The term ‘hedge fund’ drives fear into the hearts of many people,” says Ali. “It’s a no go right now, as they can’t get it past their committees.”
Transparency is also an issue, as most institutional investors like to see both the long and short positions their managers are taking, something hedge fund managers are loathe doing for fear of tipping their hand to the market.
As an index, the AlphaPro ETF purports to offer beta one, risk controlled long/short exposure with the prospect of risk adjusted out-performance. Throw in (possibly) lower fees, and institutional investors may just have a new source of alpha.
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