Before the great market meltdown of 2008, a vocal contingent of quantitative analysts pushed the notion that trading constraints forced long-only equity fund managers to leave a lot of alpha on the table. By freeing managers to express their negative sentiments on stocks through short sales, they argued, managers could lever up their favorites on the long side, enhancing returns without necessarily increasing market risk.
Take, for example, a large-cap portfolio with a mandate to beat the Standard & Poor's 500 (SPX) without assuming outsized risk. A portfolio manager could invest $100,000 in undervalued stocks from her universe, such as the SPX itself, then short $30,000 in stocks from a pool that is deemed overvalued. The proceeds from the short sale are then used to purchase an additional $30,000 in undervalued issues. Thus, the manager ends up with $130,000 invested in long positions and $30,000 in short positions. It's because of this ratio that these short-enabled portfolios are often dubbed “130/30” strategies. The portfolio's long side is levered by short sales, allowing $160 to be invested for every $100 under management.
Despite the leverage, there's no more than market risk undertaken. That's because the strategy maintains a beta of 1.00 to its SPX benchmark. That's also expressed in the ratio. The net result of being 130 percent long and 30 percent short is, after all, a 100 percent long position, or full exposure to the market.
The theoretical underpinnings of these short-enabled strategies developed from academic research on portfolio efficiency and were test-driven in the institutional market. Tests went well before the 2008 crash. Well enough that, by mid-year 2007, domestic pensions and endowments committed some $30 billion to the strategies. Worldwide investments in the strategy ballooned to $100 billion by year-end 2007.
Then, retail versions started to pop up — through nearly a dozen money management outfits — just in time for the equity market collapse. That spelled quick death for many nascent portfolios.
Many, But Not All
Two of the pioneer funds — the Old Mutual Analytic US Long/Short Fund (OADEX) and the UBS US Equity Alpha (BEAAX) — survived the crash, but were beaten up severely. They've since rebounded, but these funds are still worth less than their values three years ago. That's not surprising, since the SPX is also under water on a three-year basis. Table 1 illustrates the three-year performance of the two funds compared to the blue-chip benchmark.
The 2008 market sell-off knocked the stuffing out of the OADEX portfolio in particular. From October 2007 to September 2008, the OADEX return was ahead of its SPX benchmark by as much as 4.7 percent. Then the wheels fell off. Now, the mutual fund's cumulative three-year return is 6.1 percent under SPX's.
The BEAAX portfolio fell to a discount against SPX much sooner. After bettering the blue-chip index by 2 percent in November 2007, the UBS fund was under water before the holiday shopping season concluded. Now, BEAXX's three-year track record trails SPX by more than 7 percent.
Despite these rather bleak statistics, the 130/30 portfolios are actually faring better now. The funds' darkest days were in December 2008 when OADEX shed 47 percent of its October 2007 value and BEAXX lost 52 percent. Now the funds are off 32.6 percent and 33.6 percent, respectively.
With such performance figures, you wouldn't think money management firms would have the stomach for new 130/30 products. But there have been two noteworthy launches since the market crash. What makes them noteworthy is that these new products are exchange-traded. And they're beating the seasoned funds at their game.
New Funds
First to market with an exchange-traded 130/30 product was the KEYnotes First Trust Enhanced 130/30 ETN (NYSE Arca: JFT), floated in May 2008. The note tracks the First Trust Enhanced 130/30 Large Cap Index, a modified equal-weighted roster of securities drawn from the 2,500 largest US exchange-listed stocks.
After weeding out ADRs, REITs and limited partnerships, the First Trust index methodology ranks issues in its stock universe according to growth and value factors.
Growth factors include three-month, six-month and 12-month price appreciation, together with one-year sales growth. Value rankings are assigned on the basis of book-to-price ratios, cash-flow-to-price ratios, and returns on assets.
Top-ranked stocks go into the long pool while short positions are drawn from the lowest-ranked stocks. Rankings are reiterated for each quarterly rebalancing.
The First Trust product shouldn't be confused with an exchange-traded fund, or ETF. Interests in JFT are zero-coupon, unsecured debt obligations of JPMorgan Chase & Co. Rather than paying periodic interest, these notes entitle holders to receive the $50 face amount at maturity in 2023, adjusted for the index return. There's no assurance the face amount will be returned to noteholders. Should the since-inception index return remain negative, as is the case now, the principal return will be less than $50. If the index gains ground after accounting for yearly investor fees, more than $50 may be paid out.
Check that. May be paid out. Holders of the JFT notes undertake the same risk as other unsecured creditors of the financial institution, meaning their interests could be worthless if JPMorgan Chase becomes insolvent.
Of course, holders don't have to await maturity (or possible insolvency). They can trade the notes in the secondary market at a price tracking JFT's indicative value (IV). Disseminated every 15 seconds during the market day, the IV provides real-time pricing of the 130/30 strategy and announces possible arbitrage opportunities if the notes' market price trades at a premium or a discount.
Ostensibly, the ETN structure provides a trade-off to investors. In exchange for undertaking credit risk, investors trade away the tracking error that can beset exchange-traded products based upon actual portfolios. There's only an index underlying the notes, so there are no frictional trading costs such as bid/ask spreads, slippage or commissions to skew the IV.
Still, investors and advisors often see an alarmingly wide gulf between the notes' last sale price and their published IV. That's, however, an artifact of the notes' illiquidity. On average, only 343 JFT notes change hands on any given day. Most commonly, a day's volume is just a round lot — 100 notes. Such infrequent trading naturally leaves long gaps between the last sale — the price typically seen by investors — and the current bid/offer. Over the past year, in fact, the median difference between a trading day's last sale price and its final IV was -92 cents or -3.1 percent. In other words, the apparent market price greatly underestimates the products' actual performance.
That performance has been substantially better than that of other 130/30 products and the S&P 500 this year. JFT's IV return topped 17 percent over the past twelve months, though investors wouldn't have known that by merely looking at its last sale data. If viewed from the prism of market value, in fact, the product seems to have underperformed SPX.
JFT, too, outperformed the other exchange-traded 130/30 products — the ProShares Credit Suisse 130/30 ETF (NYSE Arca: CSM). Launched in July 2009, CSM is a more actively traded product, averaging a daily turnover of over 21,000 shares. That accounts for the average 2-cent, or .03 percent, spread between its end-of-day last sale and its net asset value.
The Credit Suisse 130/30 Index methodology is much like First Trust's. Stocks are drawn from the 500 largest-capitalized issues trading domestically and, after culling low-priced and illiquid issues, a ten-factor screen for growth, value, profitability, momentum and technical strength is run. The output issues are then ranked by their expected alpha and a portfolio of long and short positions is optimized. Unlike the First Trust index, the Credit Suisse benchmark is rebalanced monthly.
How They're Doing
Over the past year, exchange-traded 130/30 products managed to attain a self-avowed objective of the class — alpha production — but had mixed results with respect to risk containment. The ProShares fund snagged a 1.6 percent excess return over SPX (rounded to a 0.02 alpha in Table 2) while maintaining a beta slightly lower than its domestic stock universe. With annual fees of 0.95 percent, the alpha produced by CSM yields a benefit-to-cost ratio of 1.64. That's certainly better then the negative results of the high-cost OADEX and BEAAX mutual funds, but pales next the 5.65 ratio earned by the First Trust ETN.
The First Trust note's indicative value return and resulting alpha, while higher than the ProShares product, was derived with greater risk. The 1.10 beta is most likely attributable to the broader universe of stocks (2,500, including smaller issues, rather than the 500 blue-chips comprising the SPX) and quarterly rebalancing.
Now, it may be hard to conceive of a downside to higher risk-adjusted returns, but for quantitative managers, risk control is often a paramount concern. Adding a higher-beta product to a portfolio may require a manager to dial down another exposure elsewhere.
Nowadays, of course, many portfolios managers would love to have such a problem.
