Different Roads to Alpha for Different Aims
There is growing interest among investors in the return advantages of equity strategies that relax the long-only constraint. In particular, a new wave of strategies with 130% long and 30% short positions have appeared in the institutional marketplace as a means to raise active returns.  These so-called “short extension” strategies found theoretical support in a Journal of Portfolio Management article that highlighted the efficiency benefits of this structure.¹  The article's authors mathematically showed that the source of a portfolio's greatest inefficiency was the long-only constraint. By relaxing this, they argued, investors could further capitalize on a successful long-only manager's skill by allowing him to fully express both positive and negative views.

But why this interest now?  After all, the investing public has known for years that allowing talented managers to short unfavorable stocks was an efficient way to add alpha.  In fact, long-short strategies were created with this goal in mind. 

Indeed, one could argue that short extension strategies are no different than equitized long-short strategies in terms of effective active exposures.  A manager could easily replicate a short extension portfolio by shorting the underweighted stocks, purchasing the overweighted stocks, and equitizing the final portfolio with index futures or swaps.  The equitized method is simply one variation of portable alpha, which many investment managers already practice.

Despite these similarities, there are subtle but important structural differences in how the alpha can be generated. These nuances will likely enable both approaches to coexist in the arsenal of alpha-generating strategies within an investment plan. Most significantly, portable alpha structures give managers greater flexibility in taking bets and are ideal for managers with insights that extend beyond pure stock selection.  In contrast, short extension strategies retain much of the discipline and risk control associated with successful long-only equity investing.  This distinction will likely cause plan sponsors to carve out 130/30 strategies from their long-only equity allocation, while portable alpha will continue to reside in the alternatives space.

130/30 Short Extension Strategies
The appeal of a short extension strategy is straightforward.  By nature, benchmarks tend to be top heavy because the largest stocks comprise significant benchmark weight while stocks near the bottom are virtually weightless.  This makes underweighting the smallest benchmark stocks problematic, if not impossible.  As a result, a successful active manager is mathematically forced to concentrate the largest underweights among the largest stocks.  This constraint is inefficient.

By removing the long-only constraint, a certain natural symmetry is introduced to active management.  The overweights and underweights can be spread equally among larger- and smaller-cap stocks.  Now a manager can fully express both positive and negative views on stocks, unconstrained by a particular stock's market capitalization.

Everything else about the strategy can remain constant.  For example, many managers constrain sector weights and industry weights to be very similar to the benchmark weight.  In addition, quantitative managers usually constrain the size of active stock weights, often as tight as 50–100 basis points.  None of this needs to change when moving to a 130/30 structure.  Even the portfolio's beta remains at 1.  The structure is tantamount to pre-packaged alpha plus beta, identical in that sense to the profile of a long-only equity manager.

Portable Alpha
Now consider portable alpha.  These strategies equitize the underlying cash with futures positions or swaps.  The cash is then managed with the objective of outpacing short-term interest rates.  If the manager can do that effectively, the strategy return is expected to exceed that of the index.²

While there are many methods to manage the cash, an equitized long-short equity strategy most closely resembles a short extension structure. This method allows a manager to buy favored stocks and short undesirable stocks, usually in equal proportion so that the net market exposure, or beta, is zero.  The alpha from this pool can then be “ported” onto a benchmark via the futures market.

A key difference between this variant of portable alpha and a 130/30 strategy is that market neutral managers often have greater flexibility in the types of active positions they take.  For example, some of these managers may have particular insight in the technology sector and may concentrate all of the strategy's active positions accordingly.  Additionally, some managers are more thematic in nature and could implement a sector trade by purchasing an energy exchange traded fund (ETF) while shorting a financial ETF.  Alternatively, a manager may have a keen sense of market direction and move away from market neutrality, targeting a beta greater than 0. 

These are all common and accepted practices among long-short strategy managers.  They also underscore key differences between portable alpha and short extension structures. 

Long-Only with a Twist
A simple exercise demonstrates the similarity between a short extension strategy and a traditional long-only enhanced equity strategy.  We simulated a 130/30 paper portfolio.  A set of random alphas was created that ranked all stocks in the S&P 500®.  Then a portfolio was constructed aimed at maximizing the weighted average alpha score of the portfolio, while constraining sector, stock and industry misweights at 50 basis points.  The portfolio was allowed to go up to 130% on long positions and 30% on short.

Exhibit 1 reviews the major characteristics of this paper portfolio versus the S&P 500.  The capitalization, beta, and price-to-book characteristics of the portfolio are all similar to those of the benchmark.  Relative to the S&P 500, this is a style-neutral portfolio, very similar to an enhanced equity strategy. 

Exhibit 2 further decomposes the sector weights, separating the long and short positions, and reveals several insights.  First, the long and short position weights are directly proportional to the sector weights in the benchmark.  For example, the total short positions are highest within technology, consumer cyclicals and healthcare.  It is not coincidental that these three sectors are also among the six largest sectors within the benchmark.  Stock ranks tend to be symmetrically distributed by sector, which implies that sectors containing the most stocks will also contain the greatest number of long and short positions.

Note also that short positions are found in every sector.  This may provide a level of comfort to a manager's client, since concentrated short positions can be quite risky.  This is also a key differentiator from portable alpha strategies, which may have the flexibility to focus both long and short positions on a limited number of sectors.

Ultimately, the critical statistic is the net long position of the portfolio versus the benchmark.  The difference of net exposure between the strategy and the benchmark helps to measure total sector risk.  Given the tight constraints used in the optimization process, these differences and this risk are quite low.

Portable Alpha Profile
What would the profile of this strategy look like if it were run as a portable alpha strategy?  Converting a 130/30 structure to an equitized long/short strategy is a fairly easy exercise.  Below, we simply sum the active overweight and underweight positions by sector.  The active overweight holdings would be equivalent to a long position in a long/short pool.  Conversely, the underweight positions would be analogous to a short holding in that same pool.

Note the summary weights of the long and short positions.  Even though this is a 130% long and 30% short strategy, the equivalent long/short profile is actually greater than 60% long and 60% short.  This result is a consequence of managing against a benchmark.  The short extension portfolio can “fund” a large percentage of its short positions by simply underweighting the benchmark.  Another way of thinking about this is that the “short” positions in Exhibit 3 contain many positions that are not, in fact, short positions. 

The long positions and short positions by sector are even more directly related to the sector weight in the underlying benchmark than they were in Exhibit 2.  Financials, healthcare, and technology are the three sectors with the largest short positions in the converted long/short pool.  Referring back to Exhibit 2, these are also the three largest benchmark sectors by weight.

130/30 Avoids Portable Alpha's Basis Risk
There is an additional important difference between short extension strategies and portable alpha.  A short extension strategy is not dependent on a liquid equity futures contract that mimics that benchmark.  This feature carries a key advantage for managers who would like to track a large cap US benchmark different from the S&P 500.  For example, many European plans seek to track the FTSE® North American Index or the MSCI US Index^SM.  Managing the tracking error against these benchmarks is important and short-extension plans are not burdened by the basis risk created by an imperfect futures-contract match.

Alpha à la Carte
Short-extension strategies can provide a useful alternative to equitized long-short strategies, especially since, unlike some portable alpha strategies, they retain many of the same characteristics of a traditional long-only equity strategy.  The strategy's major risk characteristics such as size, style, beta, and sector risk remain the same.  The only meaningful difference is that the stock overweights and underweights are now symmetrical and independent of benchmark weights.

By contrast, portable alpha structures allow a manager greater flexibility in making bets on sectors, capitalization, or, on occasion, market direction.  In its complete form, portable alpha allows a manager to port pure alpha onto a beta allocation from a rich variety of asset classes, extending beyond the equity market.  This structure is ideal for a manager who has insights beyond, but still include, pure stock selection.

Due to these differences, both structures are likely to coexist and thrive in different portions of an investment plan's allocation.  Short-extension strategies will predominantly come from a plan's equity allocation while portable alpha will reside primarily in the alternatives space.

¹ Clarke, Roger, Harinda de Silva, and Stephen Sapra, “Towards More Information-Efficient Portfolios.”  Journal of Portfolio Management, Fall 2004.

²  Bernstein Research compiled a variety of definitions of portable alpha from various investment management organizations.  These can be found in the research report, “Portable Alpha and the Beautiful Art of Language,” March, 2006.

The FTSE® North American Index is a trademark jointly owned by the London Stock Exchange Plc and The Financial Times Limited, and is used by FTSE International Limited under licence. “All-World”, “All-Share” and “All-Small” are trademarks of FTSE International Limited.

The MSCI US Index^SM  is a trademark of Morgan Stanley Capital International. 

Standard & Poor's S&P500® Index is a registered trademark of Standard & Poor's, a division of The McGraw-Hill Companies, Inc.

Portfolio managers in this strategy may manage long-only and long-short portfolios for SSgA or its affiliates. SSgA has implemented various safeguards to address potential conflicts of interest.

This material is for your private information. The views expressed are the views of Ric Thomas only through the period ended April 13, 2006 and are subject to change based on market and other conditions. The opinions expressed may differ from those with different investment philosophies. The information we provide does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. We encourage you to consult your tax or financial advisor. All material has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation nor warranty as to the current accuracy of, nor liability for, decisions based on such information. Past performance is no guarantee of future results.

Posted On: May 11, 2006