CAMBRIDGE, Mass. A new research paper suggests institutional investors should put 130/30 strategies to a more stringent test.
The paper recommends investors stop using static benchmarks such as the Standard & Poors 500 or Russell 1000 indexes to measure performance of their 130/30 managers, switching instead to an index that actually shorts stocks.
Active extension strategies, generally referred to as 130/30s, take on more risk and use leverage, so they should not be compared against a static, buy-and-hold index, said Andrew Lo, author of the report and Harris & Harris Group Professor of Finance at the Massachusetts Institute of Technology Sloan School of Management, Cambridge.
When you use leverage and shorting, its a different animal. It has different return and risk characteristics, Mr. Lo said in an interview.
The paper suggests using a new index by Credit Suisse that uses 10 valuation criteria to rank stocks in the S&P 500, and then applies a mechanical algorithm to short the lowest-ranking stocks and invest more money in the highest-ranking stocks.
The Credit Suisse criteria are traditional value, relative value, historical growth, expected growth, profit trends, accelerating sales, earnings momentum, price momentum, price reversal and size of the company.
The mechanical algorithm would short enough stocks and go long enough stocks to replicate a 130/30 strategy. The index will be rebalanced once a month. Its performance will be able to be monitored on a publicly available website, although the website has not been determined yet.
Mr. Lo is creating another index for 130/30 strategies called the look ahead index. It looks at how stocks performed in a given month, then shows how the index would have performed had it picked the best short and long candidates. This index is not intended to serve as a benchmark for 130/30 strategies, but rather to show how the perfect 130/30 strategy would perform, Mr. Lo said.
But some managers of 130/30 strategies believe the S&P 500, or other common equity index, should remain the benchmark for the portfolios.
The ultimate index for equity strategies is a cap-weighted index. Thats the pure passive play, said Ric Thomas, managing director and head of Boston-based State Street Global Advisors North American enhanced equity group, which oversees about $12 billion in 130/30 strategies.
Mr. Thomas explained that an index is supposed to show investors whether they are gaining from active management or should just place their money in a passive portfolio.
A benchmark that ranks stocks and chooses shorts is essentially an active strategy. Instead of a benchmark, an investor would just be comparing one active strategy to another. The opportunity facing investors (when comparing a strategy to a benchmark) is what should I do with my money? Do I go for a passive play and hold stocks based on their cap weight, or do I do something active with it? Mr. Thomas said.
Other managers of 130/30 strategies also disagreed with using an active strategy for a benchmark.
Any active strategy will have inherent biases, pointed out Russell Kamp, New York-based chief executive officer for Invesco Ltd.s global structured products group.
He pointed out that the Credit Suisee index uses factors to rank stocks that give the index a value bias. It would make little sense to compare a strategy with a momentum bias, for instance, to a benchmark with a value bias, he said.
Mr. Kamp also claimed that 130/30 strategies do not need a different benchmark just because they short stocks. If youre managing a long-only strategy, youre still making short bets relative to your (corresponding) index by underweighting or not owning securities that are in the index being used as a benchmark, he said.
Mr. Lo acknowledges the idea of using an active strategy for a benchmark is foreign to most investors. A common reaction to the use of any strategy as an index is to cry foul, the paper notes, pointing out that the original motivation for having a fixed set of securities in an index was to reduce the amount of trading needed to replicate that index in a cash portfolio.
Makes it easier
Technological advances now make it easier to set up algorithms to decide what securities to short. Technology also makes it easier to trade those securities on a more frequent basis.
In the same way that recent advances in trading technology have indelibly altered the practice of portfolio management, we argue that concepts like benchmarks, indexes and passive investing are also evolving in the face of rapid technological advances in the financial markets, the paper says.
Some consultants agree that short extension strategies do require a different benchmark.
In trying to evaluate these 130/30s, you do have to be careful about how you evaluate the short side, said Brian Ternoey, investment practice leader for investment consulting firm Curcio Webb LLC, Pennington, N.J.
Mr. Ternoey, who is not familiar with Mr. Los paper, said that benchmarking for 130/30s is not a science at this point. Its harder to evaluate the value added on 130/30s because of the shorting.