Content area
Full Text
One of the fastest growing areas in institutional investment management is the so-called active extension or 130/30 class of strategies in which the short-sales constraint of a traditional long-only portfolio is relaxed. Fueled both by the historical success of long-short equity hedge funds and the increasing frustration of portfolio managers at the apparent impact of long-only constraints on performance, 130/30 products have grown to over $75 billion in assets and could reach $2 trillion by 2010 (Tabb and Johnson [2007]).
Despite the increasing popularity of such strategies, considerable confusion still exists among managers and investors regarding the appropriate risks and expected returns of 130/30 products. For example, the typical 130/30 portfolio has a leverage ratio of 1.6 to 1, unlike a long-only portfolio that does not use leverage. Although leverage is typically associated with higher volatility returns, the volatility and market beta of a typical 130/30 portfolio are comparable to those of its longonly counterpart. Nevertheless, the added leverage of a 130/30 product suggests that the expected return should be higher than its longonly counterpart, but by how much? By definition, a 130/30 portfolio holds 130% of its capital in long positions and 30% in short positions. Thus, the 130/30 portfolio may be viewed as a long-only portfolio plus a market-neutral portfolio with long and short exposures that are 30% of the long-only portfolio's market value. The active portion of a 130/30 strategy, however, is typically very different from a marketneutral portfolio so that this decomposition is, in fact, inappropriate.
These unique characteristics suggest that existing indexes such as the S&P 500 and the Russell 1000 are inappropriate benchmarks for leveraged dynamic portfolios such as 130/30 funds. A new benchmark is needed, one that incorporates the same leverage constraints and portfolio construction algorithms as 130/30 funds, but is otherwise transparent, investable, and passive. We provide such a benchmark in this article.
Using ten well-known and commercially available valuation factors from the Credit Suisse Quantitative Equity Research Group from January 1996 to September 2007, we construct a generic 130/30 U.S. equity portfolio using the S&P 500 universe of stocks and a standard portfolio optimizer. The historical simulation of this simple 130/30 strategy-rebalanced on a monthly basisyields a benchmark time series of returns that can be viewed...