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Aon Retirement and Investment Blog

130/30 Renaissance

Strategies that involve a limited amount of shorting[1], but remain beta one (maintain equity exposure), known as extended equity or 130/30 strategies, have enjoyed a renaissance of sorts recently. Investment returns for 130/30 strategies have been quite attractive in the period following the Global Financial Crisis (GFC) as highlighted below. The returns compare favorably to both the benchmarks and to the long only manager universe:

We have recently noted a (small) uptick in client interest in these types of strategies available in the market. In general, 130/30 strategies have seen a dramatic increase in assets under management (AUM), notably off a small asset base. Global equity 130/30 strategies available in the market have experienced a 45% increase in assets under management, net of market returns, over the past three years[2], rebounding somewhat from the sharp reduction in assets following 2007 and 2008. However, despite the evident interest in these types of strategies, and favorable recent performance, we believe the vast majority of investment strategies (long only or 130/30) will experience cyclical returns. Manager selection is key. Choosing the best strategies available may increase the likelihood of outperformance versus an appropriate benchmark net of fees on an ongoing basis.
Following, we examine whether recent return levels are truly sustainable when adjusting for the characteristics of 130/30 strategies.
Why might 130/30 strategies deliver better performance?
The potential for excess returns should be increased given the removal of the short constraint and lead to more efficient portfolios. Using the fundamental law of active management[3]:
Information Ratio = Transfer Coefficient × Insight × √Breadth
In theory, one may assume 130/30 strategies result in better returns due to an increase to the Transfer Coefficient, defined as the degree that a portfolio can reflect your best ideas. We note this must assume one or more of the following:

a.     The ability to increase the number of forecasts to include negative forecasts
b.    The symmetry of efficacy of the forecasts for both longs and shorts (insights to remain at least constant)
c.     The ability to construct portfolios adjusting for the complexities of shorting e.g. the differentiation between under-weights and true short positions (given the cost of borrow, etc.)

For (a), the vast majority of 130/30 strategies are managed by quantitative managers, meaning their analytical tools and capabilities allow for them to generate many forecasts. However, we believe the complexities in achieving points (b) and (c) should not be underestimated.
The vast majority of 130/30 strategies are extensions of identical traditional long only strategies. This gives us the opportunity to test whether removing the short constraint produces a superior information ratio (IR).[4] Looking at the comparative information ratios of the 130/30 strategies vs the long only equivalent[5] strategies, the results are disappointing.

Source: eVestment as of 30 September 2015
This shows[6] that on average, managers struggle to achieve a superior IR when using 130/30 strategy. However, there is also an argument that IRs are better served looking at overall portfolio level and that 130/30 strategies are suitable for a portfolio of unconstrained managers.
Measuring Returns
It is important to note that 130/30 strategies are 130% long and 30% short, which means that they have 160% exposure and that an investor deserves 160% of the excess return EVEN if there is no increase in the transfer coefficient, i.e., if there is no extra benefit from creating a portfolio with shorts.
The vast majority of 130/30 strategies have a corresponding long only strategy. Therefore, it is fairly straightforward to normalize these returns for:

  1. 160% exposure – Does it outperform 1.6 times the long only equivalent strategy?
  2. Fees (including performance based fees)
Not surprisingly, our analysis of the long only products that directly correspond to the 130/30 products show that they too have generally produced positive excess returns, the median manager outperforming its relevant benchmark by about 1% over rolling three, five and seven year periods. Generally, long only quantitative strategies have performed well in this period. Given the number of stocks in a quantitative portfolio, this may suggest alpha from both over and underweights, and it appears this has carried through to outright shorts when implemented in a 130/30 strategy. However, let’s see what happens as we make our adjustments for exposure and carry:

Exhibit Notes: Data source is eVestment as of 30 September 2015. Excess return is the median outperformance over the appropriate benchmark. The adjusted for exposure is the median outperformance normalized for 160% exposure. The adjusted exposure and carry is the median outperformance normalized for 160% exposure and assumes a 10% performance fee. The median manager excess return (compared to its benchmark) is not the same as the difference between the median 130/30 and median long only equivalent manager as they may not be the same manager.
The results, akin to the information ratio results, are relatively disappointing. Adjusting for the additional exposure and carry, there is very little alpha. Therefore, despite the potential for higher levels of alpha from removing the short constraint, the additional skills required to manage a 130/30 strategy mentioned earlier – efficacy of forecasts both long and short, and the portfolio construction nuances that come with shorting, remain a barrier to better returns. The results for more diverse, less efficient asset classes such as global equity are very similar (~50bps net of exposure and carry). However, we note that the performance of top performing global equity managers, in particular, to be much stronger.
It is probably of no surprise that results are far more encouraging for a) less efficient asset classes such as global equity and b) top performing managers. This is a reminder that there is no panacea in the search for alpha and that one is required to identify truly skilled managers in less efficient asset classes. Consistent with our “Go Big or Go Home” thesis, we believe the number of managers that can truly add alpha remains small, whether or not they implement a 130/30 framework.
Adrian Kurniadjaja is an Associate Partner in Aon Hewitt’s Global Investment Manager research group in Chicago.

[1] Long/short equity is a strategy that involves taking long positions in stocks that the investor expects to appreciate, and short positions in stocks that the investor expects to decline. 130/30 specifically indicates the long position will be approximately 130% of the portfolio, and the short position will be approximately 30%, for a total of 160% exposure.
[2] Source: eVestment
[3] The Fundamental Law of Active Management by Grinold (1989) and the Transfer Coefficient concept by Clarke et al (2002). Insight is defined as one’s ability to forecast exceptional returns. Breadth is defined as the investible universe.
[4] Information ratio is excess return divided by tracking error. Tracking error is the difference between the portfolio’s return and the benchmark’s return. A higher information ratio is preferred as it indicates a manager’s ability to generate excess return consistently over a benchmark.
[5] The comparative information ratio would be Manager A’s 130/30 IR divided by Manager A’s comparable long only strategy
[6] The exhibit may be interpreted, for example, that the information ratio over 3 years for 130/30 strategies is 110% of equivalent long only strategies.  
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