There is a misguided new movement among a handful of academics and investment firms to classify directionally long strategies such as 130/30 with hedge funds and market-neutral strategies, and develop actively managed indexes to benchmark their performance.
While directionally long strategies offer the expanded capability to pursue alpha with greater linearity through shorting, this movement miscategorizes the strategy for investors and fiduciaries. We believe that fundamental benchmarking will prove to be unreliable and specious, given the inevitable factor biases and structural inefficiencies that accompany an actively managed index.
Benchmarking investment performance is a critical tool for plan sponsors, trustees and consultants to measure both the skill and the risk that a manager assumes in deviating from a traditional passive index. Yet, the evolution of directionally long strategies has confused some in the investment community into perceiving these strategies to be more exotic than they are. Specifically, the shorting component of 130/30 and other directional strategies has led some to believe — incorrectly — that this approach is akin to an alternative strategy. By this flawed reasoning, these managers should be treated and measured differently from traditional long-only managers. We wholeheartedly disagree.
For years, investment managers have lamented the lack of linearity in their portfolio construction because of the long-only constraint of traditional portfolios. The term linearity in quantitative management circles refers to the ability to execute upon equal forecasting of long and short candidates. Traditional portfolios are, by their nature, not linear because of their inability to express underweight convictions to the same extent as overweight convictions. These strategies invest within broad indexes — such as the S&P 500, Russell 1000 and Russell 3000, and the Wilshire 5000 — that are dominated by a handful of the largest companies. Active managers have the opportunity and flexibility to significantly overweight their highest-rated stocks, but they are prohibited from underweighting their lowest-rated stocks to the same extent because of the long-only constraint. With more freedom to express both long and short views on an index's constituents, many would argue that a directionally long manager should naturally have greater likelihood for excess return. We believe that this assertion will be proven accurate, though only time and manager skill will determine if we are correct.
What is important to understand here is that unlike hedge funds or any other alternative product, a 130/30 strategy's use of shorting is opportunistic and not a hedge, as the beta of the portfolio will remain reasonably close to one. Shorting in this manner is no different than making active underweight decisions in a long-only portfolio. Thus, directionally long strategies occupy the same space as traditional long-only managers within a diversified equity program. We therefore believe that the ability to short securities against a long-only index is no different than building a value or growth, small or large cap, industry and sector, or a high beta or low beta bias into a portfolio construction process. Therefore, directionally long strategies should be compared to the same passively constructed market benchmarks to which long-only managers are compared.
What makes an effective index? Aside from being a passive bogey used for comparative purposes, an index should be transparent, broad and investible. Importantly, the return/risk assumptions should accurately represent the asset class and appeal to a broad investing public. With regard to transparency, the “rules” that determine the constituents within the benchmark should be known, with possible future changes to the index anticipated. Using an “active” approach to maintaining an index inherently corrupts this aspect of an index's purpose.
Any departure from a pure index by an investment manager creates tracking error, or risk, and needs to have a commensurate excess return associated with it to justify the exposure. A plan sponsor knows that transaction costs, management fees and other execution costs, such as borrowing costs on short positions, and unintended risks create a significant hurdle that is challenging to overcome in an investment management process. Do we really need a theoretically tougher, more complicated index to compare directionally long strategies? On the contrary, simplicity and passivity are critical elements in an index for evaluating a manager's performance, particularly when the process guidelines are expanded. When a client selects a 130/30 manager to add alpha to, say, the S&P 500, the correct index to measure that manager's success against is the S&P 500, not another actively managed strategy which itself may vastly underperform or outperform the S&P 500 at any given time.
Our strong belief is that evaluating either a quant manager's model or qualitative stock-picker's insights is best achieved when the benchmark is transparent and passive. Cap-weighted indexes such as the S&P 500 and Russell 2000 achieve this objective and give clients an appropriate way of measuring a manager's ability to generate alpha.
It only makes sense to measure us against the index used to take active risk, regardless of the way we choose to take these risks.
How can an index where there is an explicit bias toward certain fundamental factors be an objective yardstick for measuring the absolute value of a manager's skill or performance?
With the introduction of more complicated strategy indexes to measure 130/30 products, there appear to be more contradictions, more confusion and less objectivity than the marketplace needs.
Why complicate the process of performance evaluation, when you can use one index to which you can compare all of your managers, whether they are making decisions relative to small or large capitalization, growth or value, over- or underweighting industries and sectors, or investing long and short positions? Any departure from the index creates risk and hopefully a commensurate return will follow. Creating a more complicated mousetrap doesn't mean it is better.
Russell D. Kamp is the head of Invesco Quantitative Strategies, based in New York.
