Triple Take

Globalization, including the emerging market economies, has led to an increased opportunity set for global investors but at the same time, correlations among the world’s stock markets are increasing. As a result, equity portfolios diversified across the major economic regions have not experienced as much risk reduction as expected. One only has to look at the current “made in the U.S.A.” credit crisis and its impact on global markets to get a sense of how globalization is changing the road map for equity investors.

To offset this trend, investment managers and plan sponsors are increasingly looking at alternatives to the traditional long-only equity strategy for more efficient and less correlated portfolio construction methodologies. Three alternative equity-based strategies that are becoming increasingly common are long-short extension, equity market neutral and equity long-short. Each of these strategies uses leverage and actively shorts stocks, but does so through very different methods. Therefore, plan sponsors can look at each strategy on its own merits and determine its applicability to the plan’s specific circumstances.

There are a variety of academic and intuitive arguments for allowing investment managers to short stocks. For simplicity, let’s focus on the intuitive argument: long-only investment managers are not able to make efficient use of all of their research because they are prohibited from shorting stocks that they believe will underperform relative to the stock market and their long positions. The argument for removing the long-only constraint becomes even stronger considering that approximately 85% of the stocks in the S&P/TSX Composite Index have weights under 0.5% and approximately 90% in the Russell 1000 have weights under 0.2% (according to data from TSX Datalinx and UBS).

To demonstrate the impact of this issue, let’s assume that an investment manager is able to successfully find two different stocks that are both going to decline by 25% over the next 12 months. Despite having equally strong—and accurate, in this example—views on both stocks, the only option available to the long-only manager is not to hold either stock in the portfolio. In the example shown in Figure 1, this is akin to taking a -2.5% position in Company A stock and a -0.5% position in Company B stock, relative to the market index.

With a long-short strategy, the manager has the latitude to take a position in line with his or her conviction that the stock will decrease in price. The long-short manager can actively short Company B stock to take an active position of -2.5% relative to the index. This gives the manager the same opportunity as simply not holding Company A stock (due to its larger weight in the index). Relaxing the long-only constraint allows the long-short investment manager to profit equally from the negative views on stocks regardless of their respective weights in the index, resulting in more efficient use of the investment manager’s research.

1) Long-short Extension (130/30 Strategies) A long-short extension strategy removes the long-only constraint by a predetermined and constrained amount. Although the strategy can be set up in any predetermined ratio, the most common of late has been the 130/30 strategy. In combining a long-only portfolio with limited amounts of leverage and shorting, 130/30 strategies create a portfolio of both long and short equity positions, which, in combination, maintain a net market exposure equal to 100%. A 130/30 strategy will invest $130 in long stock positions and $30 in short stock positions for a net market exposure equal to $100.

Similar to a long-only strategy, the objective of a 130/30 strategy is to outperform an applicable equity benchmark. Additionally, if an investment manager offers both a longonly fund and a 130/30 fund using the same investment approach, a successful 130/30 fund should outperform the long-only version. Early indications suggest that 130/30 strategies have been able to add value relative to comparable long-only funds. However, data is limited, as most investment management firms have only recently introduced the strategy.