Enhanced Equity Strategies
The July/August edition of the Financial Analysts Journal (Vol 63, No 4) leads with an article about enhanced active equity strategies, which are gaining prominence both in Australia and overseas. The article titled "20 Myths About Enganced Active 120-20 Strategies" was written by Bruce I. Jacobs and Kenneth N. Levy, CFA.
Enhanced active strategies such as 130-30 or 120-20 strategies have short positions that offset a certain percentage of long positions. They are facilitated by prime brokers which allow the proceeds from short selling equities to be applied to the purchase of long equity positions. This subject was the topic of an earlier post on this blog where the it was debated at the Absolute Returns Funds Conference in Melbourne 23 August 2007.
Not all the "Myths" raised in the article are directly applicable to Australian investors, but those that deserve highlighting include:
Myth 1: Long-only portfolios can already underweight securities by holding them at less than their benchmark weights, so short selling offers little incremental advantage.
Without short selling, a hedge fund manager cannot underweight many securities by enough to achieve a meaningful active negative weight, being limited to the difference between a stock's weight in a benchmark (which might itself be zero) and zero.
Myth 7: Enhanced active equity portfolios are inherently much more risky than long-only portfolios because they contain short positions.
Losses on short positions are theoretically unlimited because a security's price can rise without limit. However, with proper diversification, losses in some positions should be mitigated by gains in others. This risk can also be managed by re-balancing position sizes for price changes.
Myth 9: The leverage in an enhanced active equity portfolio results in leveraged market return and risk.
The net exposure in such strategies is generally 100%. The leverage and added flexibility can be expected to increase excess return and residual risk relative to benchmark. So if the manager is skilled at security selection and portfolio selection, any incremental risk borne by the investor should be compensated for by increental excess return.
The article is broadly supportive of enhanced active strategies, particularly when compared with long-only strategies, by offering greater flexibility in portfolio construction and allowing for fuller exploitation of investment insights ie they enable the amplification of a manager's alpha. They don't of course deliver alpha where alpha isn't already present.
By Rick Steele
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