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Penn STAT 434 - An Empirical Analysis

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An Empirical Analysis of 130/30Strategies: Domestic and Inter-national 130/30 Strategies AddValue Over Long-Only StrategiesGORDON JOHNSON, SHANNON ERICSON, AND VIKRAM SRIMURTHYGORDON JOHNSONis a senior portfolio man-jgcr, incermitional invcst-meius, it Lcc MundtrCapital Group in Boston.MA.gjohnsnn^ Iceniundcr.comSHANNON EHJCSONIS a porttulio nuinat^er,international investments, atLee Munder Capital Groupin IJosron. [email protected] SRIMURTHYis a pt)rtfoli<t manager,international investments. Jtl-oc MmultT Capital Gronpin Boston. MA.vsrimurthy @'leemurder.comThere is growing interest in the mar-ketplace for enhanced active equitystrategies as investors search forhigher alpha in an era of lowere.xpected returns. Evidence otjust how pop-ular these strategies have become is apparentin the tremendous growth in assets over thelast year. Investment industry periodicals esti-mate that as.sets in these strategies may be ashigh as $60 billion by mid 2007 and couldreach S5()0 billion within five years.' Anenhanced active strategy partially removes thelong-only constraint, allowing managers toshort Li portion of their portfolio to enhanceactive returns. Enhanced active strategies, alsoreferred to as constrained loti^'^-sliort, active exten-sion, and short enabled, are often identified bytheir long and short target weights. Forexample, a portfolio that can short 20% and golong an additional 20% for a total of 120%long is known as a 120/20 portfolio. Similarly,a portfolio that can short 30% is called a130/30, and so on. Although the percentagethat can be sold short typically ranges from20% to 50%, 30% seems to be emerging as themost widely used in the industry. Conse-quently, in this article, we focus specifically onthe 130/30 variation.A traditional long-only strategy invests100% in securities and is managed to a bench-mark. Because a long-only strategy is prohib-ited from shorting, the most a portfoliomanager can underweight a stock is its weightin the benchmark. With a 130/30 strategy,100%! is invested in equities and the manageris allowed to short up to 30%) of the portfoho.Proceeds from, the shorts are then used to pur-chase 30%) of additional securities, so that thenet market exposure of the portfoUo remains100% as in a long-only portfolio." The abilityto short allows managers to underweiglit unat-tractive stocks in a more meaningful way thatmore accurately refiects negative return expec-tations. In contrast to a long-only strategv', anenhanced acti\'e sn'ategy levels the playing field,allowing managers to overweight and under-weight positions by the same magnitude. Evenmodest amounts ot shorting can dramaticallyimprove performance results since a managersexpectations for outperformance as well asunder performance are now better representedin the portfolio. In fact, not only does anenhanced active strategy increase expectedreturn, it is achieved without dramaticallyincreasing active risk.Conversations with Wall Street firms indi-cate that between 60% and 80% of the 130/30strategies currently in the miirketplice aa' qu.m-titatively run. Tliis is largely because such strate-gies are particularly well suited to quantitativemanagement. Quantitative models rank stocksfi-om best to worst on a variety of factors. Thelower tail of unattractive stocks is .ilre.idy beingidentified as part of a quantitative long-onlyprocess. However, the inforni:idoii in the lowertail is not flilly incorporated into the portfolio.2(X17Ti-iE JQUIINAI OF ALTERNATIVE iNvrsTMtiN i^ 31Removing the long-only constraint allows a manager tounderweight the lower tail of stocks by amounts that arecomparable to portfolio overweights in the upper tail. Inaddition, quantitative managers are often heavy usei-s of riskmodels and portfolio construction tools. Thus, they arealready well equipped to run this type of strategy in ahiglily risk controlled manner. Conversely, traditional man-agers may require additional analysts to identify short rec-ommendations or may need to revise their investmentphilosophy or existing tools to look for short opportuni-ties. This article focuses on 130/30 portfolios from thequantitative managers perspective, as quantitative man-agers dominate the 130/30 marketplace and the strategylends itself weU to this style of management.In this article, we provide further evidence that anenhanced active strategy can add value over a long-onlystrategy, but examine it from an empirical perspective.We develop a quantitative alpha (stock selection) modeland use it to test historical performance over a 13-yearperiod for 130/30 and long-only large-cap strategies inboth domestic and international universes. The 130/30strategics, using the illustrative alpha model, substantiallyoutperform their respective long-only portfolios. Theportfolio tracking errors also increase versus their respec-tive benchmarks but proportionally by much smalleramounts.Finally, we provide details on calculating perfor-mance attribution for the long and short portions of a130/30 strategy given that no industry norms have yetevolved. One of the key elements of our perspective onperformance attribution is based on the belief that a130/30 strategy is more similar to a long-only strategythan a hedge fund strategy. Thus, its performance shouldbe measured and evaluated versus the benchmark againstwhich it is managed. We compute long and short per-formance attribution for the 13-year historical 130/30tests. We find that both the longs and shorts contributeto perform.mce relative to the benchmark in most of theyears of the test period.PREVIOUS EVIDENCE ON THE BENEFITSFROM RELAXING THE LONG-ONLYCONSTRAINTGrinold and Kahn [2000] show that a portfolio'sefficiency, measured by the information ratio (IR),increases wben the long-only constraint is removed.They fmd that fully leveraged long-short strategies offerthe most improvement over long-only strategies whenthe universe of assets is large, the asset volatility is low,or the strategy has high active risk. Their analysis alsohighlights that the long-only constraint induces negativesize bias because the manager can only underweightlarge-cap stocks by a meaningful amount. This size biasatlects active long as well as short positions. They con-clude that the most important argument for long-shortinvesting is the enhanced portfolio efficiency that resultsfrom being able to short stocks where the manager hasnegative views.Clarke, de Silva, and Sapra [2{)04| evaluate infor-mation loss related to


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