130/30 Long short strategy
130/30 Long short strategy1. What is 130/30 long-short
investing?
A 130-30 fund is a type of collective investment vehicle, often
a type of specialty mutual fund, but which allows the fund manager
simultaneously to hold both long and short positions on different
equities in the fund. Traditionally, mutual funds were long-only
investments. 130-30 funds are a fast growing segment of the
financial industry; they should be available both as traditional
mutual funds, and as exchange-traded funds (ETFs). While this type
of investment has existed for a while in the hedge fund industry,
its availability for retail investors is relatively new. The 130-30
funds work by investing, say, 100 in a basket of stocks. They then
short 30 in stocks that they believe to be overvalued. Proceeds
from that short sale are then used to purchase an additional 30 in
stocks thought to be undervalued. The name reflects the fact that
the manager ends up with 130 invested in traditional long positions
and 30 invested short.
One might wonder why 130/30 instead of 120/20, or 160/60? The
reason that most of these funds hover around 130/30 is that below
that amount of leverage, it looks like the returns aren't yet
optimal, but that above that amount of leverage, the risk
magnifies. To put it simply, in risk/reward terms, a 130/30 mix
seems to be the optimal mix.2. Who is running 130/30 funds?
To date, 130/30 investing is most prevalent in the institutional
world, specifically in separately managed accounts.3. Are 130/30
funds popular now?
- Investors want more alpha
- Active risk has declined
- Less constrained strategies are becoming standard of
investing
- However, sice they were emplyed by quantitiative funds that
suffered during market downturn, popularity of these strategies has
decreased. JP Morgan observed a pick up in iverstors interest in
this strategy in later part of 2010.
4. What is the level of beta of 130/30 funds?
130/30 portfolios hold positions that are different than the
benchmark (undervalued stocks are overweighted and overvalued
stocks are underweighted) and they target a beta of 1.0 relative to
their benchmark. Benchmarks used: S&P 500 130/30 Strategy
index, S&P/TSX 60 130/30 Strategy Index. 5. Alpha vs tracking
error of long only and 130/30 fundsFor both strategies, predicted
alpha goes up as target risk goes up. Taking larger active weights
leads to higher target tracking error and higher predicted alpha.
Without any constraints or transaction costs, the increase in
active weights and the corresponding increase in predicted alpha
would be proportional to the increase in risk (e.g., double the
risk, double the active weights, and double the alpha). However,
with a constraint on shorting, the relation between target risk,
active weights, and predicted alpha is no longer proportional.
Consequently, additional increases in risk lead to progressively
smaller and smaller improvements in predicted alpha (dashed line on
the graph below). Eventually, the improvement in predicted alpha is
so small relative to the increase in target tracking error that a
further boost in risk does not make sense. By relaxing the
no-shorting constraint, the predicted alpha remains attractive even
at higher levels of risk.
alpha
Trackig error
130/30
Long-only
