The 130/30 structure employs equal amounts of long enhanced (leveraged) exposure and short exposure so that the target net long exposure of the portfolio is always 100% of assets. Constructing a 130/30 portfolio is straightforward. Assume the portfolio manager is managing a $100 mandate. The 130/30 manager buys $100 of equities; he then shorts $30 of equities. The portfolio now stands at $100 long/$30 short. Then the 130/30 manager uses the proceeds from shorting $30 of equities to buy an additional $30 of long equities. Now the portfolio contains $130 long equity exposure and $30 short equity exposure. The 130/30 manager has created a portfolio with a gross exposure (long exposure + short exposure) of 160%. The portfolio has a net exposure (long exposure - short exposure) of 100%, which mirrors the target net long exposure of a fully invested traditional manager.
Unlike absolute return-oriented alternative investments (ie, equity market neutral), 130/30 portfolios are relative return strategies that track underlying equity benchmarks. The use of enhanced long exposure and short exposure within the strategy requires the investment manager (or plan, if implemented via a separately managed account) to employ a prime broker for stock loan, financing and custodial services.
Expected information ratios meaningfully improve with the use of 130/30 strategies as a result of more efficient portfolio construction. With the additional 60% of active weights, a portfolio manager can strive to increase expected alpha by 60% (or more). Using appropriate portfolio construction techniques such as optimisation, the additional exposure can be added without increasing overall portfolio risk - hence improving expected IR.
Market conditions and pension demographics have put more pressure on plans to meet funding obligations. Therefore investors are expanding their approach to "core" investment strategies to help assuage their alpha concerns; many see 130/30 as a convenient bridge between tightly constrained long-only programmes and unconstrained alternative investment strategies. Also, the 130/30 strategy can be deployed without the use of derivatives, which is an attractive proposition for many plans.
Quantitative investment managers were the early movers within the space and institutional clients were the early adopters. Quant managers utilised their processes and research findings to demonstrate the value-add of the strategy to institutional investors. In turn, institutions have pushed non-quantitative investment managers to explore 130/30 strategies.
These reverse-inquiries (along with managers' expectation of enhanced excess returns on a risk-adjusted basis) have created a groundswell of interest in the strategy. Fundamental long-only investment managers are now beginning to explore 130/30 strategies and alternative managers are also extending into this space.
We work closely with plan sponsors who are contemplating allocating assets into 130/30 programmes. From our ongoing dialogues, we have identified the following themes as ingredients for successful 130/30 products:
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Most importantly, investment managers must have robust stock selection because the 130/30 strategy magnifies it.
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Portfolio construction and risk management also take on added importance. Building and managing a 130/30 portfolio must be done while maintaining beta and targeting other relative exposures.
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The trading desk must also have proper control procedures in place to ensure that allocation methodology is fair and equable especially if long-only strategies are being run alongside 130/30 strategies.
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Operational expertise and infrastructure must be available to the investment manager to support long/short exposure. Robust portfolio accounting, performance calculation, and performance attribution systems are needed to support 130/30 strategies.
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Stakeholder education is of the utmost importance in integrating 130/30 strategies into a plan's portfolio. This education stretches from investment staff to trustee-level personnel.
Michael Kilgallen is a director of Citi Prime Finance, based in New York.
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