Equity market neutral and active extension strategies can be defined as active equity portfolios that take both long and short positions. The key difference between this approach and a conventional one is the relaxation of the long-only constraint, enabling managers to better reflect their investment views both positive (through long positions) and negative (through short positions). As such, these strategies represent a natural extension of the traditional long-only active equity management.
In traditional long-only portfolios, underweight positions are limited to index weights. As a result, a manager with a strong negative view on a stock is limited to a zero weight, which wastes information and undermines potential opportunities for returns. Active extension strategies offer the first step toward greater flexibility for managers to express their views by partially relaxing the long-only constraint. These strategies maintain market exposure while allowing for modest shorting (typically 20% to 30%). As a result, an active extension strategy manager can better reflect investment views through both long positions and some shorting, as well as achieve more efficient use of capital by using proceeds from short selling to overweight best ideas.
Equity market neutral (or portable alpha) strategies completely eliminate the long-only constraints and deliver portfolios that aren’t constrained by a benchmark, have no market exposure and are 100% long and 100% short.
Moving from core long-only to active extension and, furthermore, to market neutral strategies immediately increases the range of opportunities for managers to better align portfolio weights with stock forecasts and minimizes wasted information. It also allows for better positioning in less liquid and smaller parts of the portfolio, leading to improved portfolio risk-return characteristics.
Opportunities to reduce risk
Equities account for the greatest source of risk in an institutional portfolio, with a typical allocation to equities and fixed income of 60% and 40%, respectively. This is true whether risk is defined in an absolute sense (an asset-only context) or relative to a pension plan’s liabilities (an asset-liability context). Based on this fact, there are four ways to reduce risk:
- Reduce interest rate risk by adding to fixed income investments and/or extending the duration of the fixed income holdings.
- Diversify the equity risk into other return-seeking alternatives such as real estate and infrastructure.
- Reduce equity risk with a low volatility strategy.
- Further diversify and customize the level of portfolio risk with equity market neutral strategies, by decoupling the alpha from the beta and thus creating portability.
Absolute return focus and low correlation with traditional market indices make market natural strategies valuable tools in the portfolio-construction process. Plan sponsors can use market neutral strategies to customize the level of risk and market exposure and achieve a more intelligent overall risk budget in a portfolio.
Bill Tilford is head, Quantitative Investments, RBC Global Asset Management