20 Myths About Enhanced Active 120-20 Strategies

by Bruce I. Jacobs and Kenneth N. Levy, Financial Analysts Journal. July/August 2007

The articles in this section discuss the construction of portfolios that take advantage of short selling to expand investment opportunities and enhance performance beyond that available from long-only portfolios.

Hedge funds and a limited number of other investors have long recognized the potential benefits of shorting selected issues in certain market environments. Jacobs Levy Equity Management was among the first money managers to explore the potential of short selling within the framework of disciplined, engineered equity management. Engineered long-short portfolios offer the benefits of shorting within the risk-controlled environment of quantitative portfolio construction.

Short selling can be used to enhance the implementation of insights from the stock selection process. Most fundamentally, it expands the list of implementable ideas from “winning” securities to “winning” and “losing” securities. A long-only portfolio, for example, can sell a loser, if it happens to hold the stock, or refrain from buying a loser; in either case, the potential impact on portfolio return relative to the underlying benchmark is limited absolutely by the weight of the security in the benchmark. When shorting is allowed, by contrast, a portfolio can achieve significant security underweights as easily as it achieves security overweights. The manager’s ability to implement insights is thus enhanced.

Short selling can also expand the profile of risk-return tradeoffs available from the portfolio construction process. Through the use of short sales, for example, one can engineer portfolios that balance equal dollar amounts and equal market-relative risks long and short. The balanced long and short positions neutralize the “market-neutral” portfolio’s exposure to the underlying benchmark; the portfolio does not incur systematic risk, nor does it earn the market return. The long-short portfolio does earn the returns on the individual securities held long and sold short, and incurs the associated security selection risks.

Long-short investing does entail costs, including any “haircut” on the cash proceeds from the short sales and any opportunity costs imposed by uptick rules and restricted share borrowability. Many of the perceived “costs” of long-short investing, however, are more myth than reality. “20 Myths About Long-Short” (Financial Analysts Journal 1996) discusses some of the misperceptions that arise when one views long-short investing through a long-only lens. It demonstrates that long-short investing, when properly implemented, is not necessarily any riskier or costlier than long-only investing.

“Enhanced Active Equity Strategies: Relaxing the Long-Only Constraint in the Pursuit of Active Return” (Journal of Portfolio Management. Spring 2006) discusses long-short strategies that take advantage of modern prime brokerage structures to allow portfolio managers to use the full cash proceeds from short sales to purchase equal amounts of securities to hold long. The article describes these strategies, including 120-20 portfolios, and gives concrete examples of their benefits over long-only strategies. Enhanced active equity strategies permit meaningful security underweight positions while retaining full market exposure.

These types of strategies are explored further in 20 Myths About Enhanced Active 120-20 Strategies. Compared with long-only portfolios, both enhanced active long-short portfolios and market-neutral long-short portfolios offer investors greater flexibility to underweight stocks and to diversify risk. Compared with market-neutral long-short portfolios, however, enhanced active portfolios maintain full exposure to the underlying market and allow for the expansion of long positions. It can be shown that enhanced active and equitized market neutral long-short portfolios are equivalent, having identical active weights and identical market exposure, but that the enhanced active portfolio is more compact and uses less leverage than the equitized portfolio.

As editors of and contributors to Market Neutral Strategies. Bruce Jacobs and Ken Levy bring together a select group of investment practitioners to discuss the implementation, benefits, and risks of long-short equity investing, convertible bond hedging, merger and mortgage arbitrage, and sovereign fixed-income arbitrage. All these market neutral strategies have the same basic aim as more conventional active strategies: to buy low and sell high. In more traditional approaches, however, the buying and selling are sequential events, whereas in market neutral they are more often concurrent.

Key Articles:

· “20 Myths About Enhanced Active 120-20 Strategies,” by Bruce I. Jacobs and Kenneth N. Levy, Financial Analysts Journal, July/August 2007; and abstracted in CFA Digest, November 2007. (1) article

Enhanced active equity strategies, including 120-20 and 130-30 portfolios, have become increasingly popular as managers and investors search for new ways to expand the alpha opportunities available from active management. But these strategies are not always well understood by the financial community. How do such strategies increase investors’ flexibility both to underweight and overweight securities? How do they compare with market neutral long-short strategies? Are they significantly riskier than traditional, long-only strategies because they utilize short positions and leverage? This article sheds some light on many of the common “myths” regarding enhanced active equity strategies.

· “Enhanced Active Equity Strategies: Relaxing the Long-Only Constraint in the Pursuit of Active Return,” by Bruce I. Jacobs and Kenneth N. Levy, The Journal of Portfolio Management. Spring 2006. (2) article

Enhanced active equity investing relaxes the long-only constraint by permitting short sales, while maintaining full exposure to equity market return and risk. The enhanced active equity approach is facilitated by modern prime brokerage structures that allow investors to use the proceeds from short sales to purchase long positions. Freeing equity portfolios from the long-only constraint can enhance performance by permitting meaningful underweight positions that are simply not achievable in long-only portfolios. The investor can thus more fully exploit security valuation insights.

Other Articles:

· “Enhanced Active Equity Portfolios Are Trim Equitized Long-Short Portfolios,” by Bruce I. Jacobs and Kenneth N. Levy, Journal of Portfolio Management, Summer 2007; and abstracted in CFA Digest, February 2008. article

How does an enhanced active equity strategy such as a 120-20 or 130-30 portfolio differ from an equitized long-short strategy—that is, a market neutral long-short portfolio with an equity market overlay? This article looks at the relationship between enhanced active equity and equitized long-short portfolios and demonstrates that an enhanced active equity portfolio can be shown to have an equivalent equitized long-short portfolio, but the enhanced portfolio has the advantage of being more compact and requiring less leverage.

· “The Long and Short on Long-Short,” by Bruce I. Jacobs and Kenneth N. Levy, The Journal of Investing. Spring 1997; and abstracted in The CFA Digest. Fall 1997.(3) article

By balancing long positions in equities with short positions of roughly equal dollar amount and market sensitivity, it is possible to construct a portfolio whose return is neutralized against overall market moves. Properly constructed, using an integrated optimization process, a long-short portfolio offers advantages over long-only portfolios in enhanced flexibility to pursue return, control risk, and allocate assets. Any additional costs should not outweigh the benefits of such a strategy.

· “20 Myths About Long-Short,” by Bruce I. Jacobs and Kenneth N. Levy, Financial Analysts Journal. September/October 1996. article

Popular conceptions of long-short investing are distorted by a number of myths, many of which appear to result from viewing long-short from a conventional investment perspective. Long-short portfolios differ fundamentally from long-only portfolios in construction, in the measurement of their risk and return, and in their implementation costs. Furthermore, long-short portfolios allow greater flexibility in security selection, asset allocation, and overall plan structure.

· “More on Long-Short Strategies,” by Bruce I. Jacobs and Kenneth N. Levy, Financial Analysts Journal. March/April 1995 (letter in response to Richard Michaud, “Are Long-Short Equity Strategies Superior?” Financial Analysts Journal. November/December 1993 and to follow-up letter by Robert Arnott and David J. Leinweber, “Long-Short Strategies Reassessed,” and Michaud’s “Reply,” Financial Analysts Journal. September/October 1994). article

Some argue that a long-short portfolio can improve upon the risk-return tradeoff of a long-only portfolio only if it reduces risk via the diversification benefits of a less-than-one correlation between the alphas of the long and short components. But this conclusion rests on the assumption that the long component of the long-short portfolio, the short component, and the comparable long-only portfolio are essentially identical, index-constrained portfolios. When long and short positions are chosen simultaneously, however, in an integrated optimization, the result is a single portfolio that is not constrained by index weights. With freedom from index constraints, the manager enjoys added flexibility, vis-а-vis a long-only manager, in implementing investment insights. This should translate into improved performance.

· “Long/Short Equity Investing,” by Bruce I. Jacobs and Kenneth N. Levy, The Journal of Portfolio Management. Fall 1993; abstracted in The CFA Digest. Winter 1994; also translated in The Security Analysts Journal of Japan. March 1994.(4) article

Investors who have the flexibility to invest both long and short can benefit from both “winners” and “losers.” This will be especially advantageous if the latterthe short-sale candidatesare less efficiently priced than the winnersthe purchase candidates. This is likely to be the case in markets in which investors hold diverse opinions and short selling is restricted. Short positions can be combined with long positions to create market-neutral or equitized strategies. The payoff patterns to these strategies differ; market-neutral portfolio performance is independent of the broad market, while equitizing a long-short portfolio restores exposure to market risk and return. Practical issues to be considered include restrictions on shorting, trading requirements, custody issues, and tax treatment.

· Market Neutral Strategies . by Bruce I. Jacobs and Kenneth N. Levy, Eds. John Wiley & Sons, Hoboken, NJ, 2005.

Market neutral strategies have gained attention in recent years for their potential to deliver positive returns regardless of the underlying market’s direction. Market Neutral Strategies provides readers with insiders’ views of the risks and benefits of these strategies and how they can be implemented. The book covers long-short equity portfolios, convertible bond hedging, merger and mortgage arbitrage, and sovereign fixed-income arbitrage. Additional chapters cover the tax implications of market neutral investing for taxable and tax-exempt investors; the “transportation” of alpha from a particular market neutral strategy to other asset classes; and the failure of two notorious “market neutral” hedge funds, Askin Capital Management and Long-Term Capital Management.

· Equity Management: Quantitative Analysis for Stock Selection . by Bruce I. Jacobs and Kenneth N. Levy. McGraw-Hill, New York, NY, 2000. Authorized Chinese translation from English language edition, McGraw-Hill, China Machine Press, 2006.

Bruce Jacobs and Ken Levy have long been recognized as pioneers in quantitative equity management. In the 1980s, they began to publish a series of articles in the peer-reviewed Financial Analysts Journal. Journal of Portfolio Management. and Journal of Investing. These articles were based on the authors’ own research into and experience with detecting and exploiting the recurring profit opportunities available in a supposedly efficient marketplace. Together, they outline an approach for selecting stocks and constructing portfolios that has the potential to deliver superior returns over time.

Equity Management collects 15 of these articles, from 1988’s Disentangling Equity Return Regularities through 1999’s Alpha Transport with Derivatives. These are grouped into three parts that cover the range of Jacobs and Levy’s investment philosophy and strategy, from selecting securities to engineering portfolios to expanding opportunities with short selling and derivatives. New introductory material provides a perspective on the articles, placing each within the broader context of the investment body of knowledge.

The authors’ approach to security selection begins with the concept of a complex market. In their view, U.S. security prices are not efficient, nor random and unpredictable. Neither, however, is the market a simple system; simple rules such as buy low P/E or buy value will not be able to yield consistent investment profits. Rather, a complex market is permeated by a web of return regularities. Furthermore, these regularities are interrelated and must be disentangled in order to arrive at real sources of return. Disentangling requires analyzing multiple promising return-predictor relationships simultaneously. The resulting pure estimated returns are additive and more robust than those from simpler, one-factor analyses.

The breadth of return-predictors considered in the security selection process, as well as the depth of analysis, help to capture the complexity of market pricing. But predictors can differ across different types of stocks. This dimension of complexity is best captured by viewing the broadest possible range of stocks through a wide-angle analytical lens. This is the case when the model used for analyzing individual stocks incorporates all the information available from the broad universe of stocks. This approach offers a coherent framework for analysis and is poised to take advantage of more information than a narrower view of the market (one focusing on particular styles or segments, for example) might provide.

Maximizing the opportunities detected in the security selection process requires a disciplined approach to portfolio construction. Quantitative techniques such as optimization are best suited to ensuring that opportunities are maximized, while risks are controlled. Proprietary portfolio optimization, in which the portfolio is optimized along the same dimensions that are considered in the security selection process, can further enhance portfolio performance.

Allowing for short sales expands investment opportunities, hence has the potential to improve performance. When long and short positions are balanced, the resulting portfolio is market neutral; its performance should reflect the returns and risks of the individual constituent securities, but not the performance of the market from which those securities were selected. Long and short positions are best determined in a single, integrated optimization. This frees the portfolio from benchmark weight constraints and allows it more flexibility in the pursuit of return and control of risk.

A long-short portfolio reflects the ability of the manager to select securities. The alpha, or excess return, from this security selection can be transported (along with its associated risk) to virtually any desired asset class via the purchase of derivatives on that asset class. The investor can thus take advantage of manager skill, wherever it lies, while maintaining an asset allocation that would not ordinarily encompass the securities exploited by the skilled manager.

Together, the articles in Equity Management provide a fascinating review of the concepts that form the foundation of modern active equity management.

Chinese Translation

Book Chapters:

· “Long-Short Equity Portfolios,” by Bruce I. Jacobs and Kenneth N. Levy, in Frank J. Fabozzi and Harry M. Markowitz, Eds. The Theory and Practice of Investment Management. John Wiley & Sons, Hoboken, NJ, 2011. Earlier versions appeared in Frank J. Fabozzi, Ed. Handbook of Finance, Volume II: Investment Management and Financial Management. John Wiley & Sons, Hoboken, NJ, 2008; and in Frank J. Fabozzi, Ed. Short Selling: Strategies, Risks, and Rewards. John Wiley & Sons, Hoboken, NJ, 2004.

Combining long and short positions in a single portfolio increases flexibility in pursuit of return and control of risk. This increased flexibility reflects the greater freedom to act on negative insights afforded by the ability to sell short as well as the freedom from traditional index constraints afforded by the ability to offset long and short positions. Long-short portfolios also offer increased flexibility in asset management.

· “Using a Long-Short Portfolio to Neutralise Market Risk and Enhance Active Returns,” by Bruce I. Jacobs and Kenneth N. Levy, in Ronald A. Lake, Ed. Evaluating and Implementing Hedge Fund Strategies, 3 rd Edition. Euromoney Institutional Investor PLC, London, U.K. 2003 (also in 2 nd Edition, 1999).

A market-neutral long-short portfolio is constructed so that the dollar amount of securities held long equals the dollar amount of securities sold short and the short positions’ price sensitivity to market movements equals and offsets the long positions’ sensitivity. Because the portfolio’s value does not rise or fall just because the broad market rises or falls, the portfolio is said to have a beta of zero. This does not mean the portfolio is riskless; it will retain the risks associated with the selection of the individual securities held long and sold short. But, with insightful security selection, the portfolio can reap commensurate rewards.

Conference Proceedings and Other Media:

· “20 Myths About Enhanced Active 120-20 Strategies,” FAJ Webcast, September 19, 2007. Webcast

Enhanced active equity strategies, including 120-20 and 130-30 portfolios, have become increasingly popular as managers and investors search for new ways to expand the alpha opportunities available from active management. But these strategies are not always well understood by the financial community. How do such strategies increase investors’ flexibility both to underweight and overweight securities? How do they compare with market neutral long-short strategies? Are they significantly riskier than traditional, long-only strategies because they utilize short positions and leverage? This article sheds some light on many of the common “myths” regarding enhanced active equity strategies.

· “Controlled Risk Strategies,” by Bruce I. Jacobs, in Terence E. Burns, Ed. ICFA Continuing Education: Alternative Investing. Association for Investment Management and Research (today the CFA Institute), Charlottesville, VA, 1998.(5)

Long-short investing is a controlled risk strategy that allows the manager to act on all of his or her investment insights without regard to benchmark constraints. Long-short is not an asset class, but a portfolio construction method in which the manager neutralizes market risk by balancing the average betas of short and long positions in the portfolio. Long-short increases the manager’s flexibility to pursue return and control risk. The manager can overweight or underweight stocks by as much as his or her insights (and client risk tolerances) allow. Furthermore, the manager can use offsetting long and short positions to fine-tune overall portfolio risk. This added flexibility should be reflected in portfolio performance. Long-short portfolio performance can be “transported” to virtually any asset class. For example, a long-short portfolio can be “equitized” using stock index futures; the equitized long-short portfolio will reflect the risk and return of the broad equity market and the flexibility advantages of its long-short component. Operational considerations that need to be considered before implementing a long-short strategy include margin requirements, the size of the liquidity buffer, trading requirements, management fees, and taxes.

· “A Long-plus-Short Market-Neutral Strategy,” by Bruce I. Jacobs and Kenneth N. Levy, in Diana R. Harrington and Robert A. Korajczyk, Eds. ICFA Continuing Education: The CAPM Controversy: Policy and Strategy Implications for Investment Management. Association for Investment Management and Research (today the CFA Institute), Charlottesville, VA, 1993.

Investors who can invest both long and short can benefit from both “winners” and “losers,” gaining alpha from both sides. Furthermore, there are reasons to believe that selling short losers may have more profit potential than buying winners; this will be the case in a market characterized by diverse investor opinions and restrictions on short selling. Long and short positions can be combined in market-neutral or “equitized” portfolios; a market-neutral portfolio’s performance is independent of underlying market moves, while an equitized portfolio retains exposure to the market. Any active equity management style can be implemented in long-short mode, but quantitative approaches have some advantages. Long-short strategies do not constitute a separate asset class; they can be categorized by existing asset classes, so that their fit in an overall investment program becomes apparent.

Industry Press Publications:

· “Market-Neutral Strategy Limits Risk,” by Bruce I. Jacobs and Kenneth N. Levy, Pension Management. July 1995.

This is a basic primer on long-short strategies. Balancing long and short positions in a portfolio can virtually eliminate the portfolio’s exposure to broad market movements.

· “The Generality of Long-Short Equitized Strategies: A Correction,” by Bruce I. Jacobs and Kenneth N. Levy, Financial Analysts Journal. March/April 1993 (letter in response to C.B. Garcia and F.G. Gould, “The Generality of Long-Short Equitized Strategies,” Financial Analysts Journal. September/October 1992). article

An erroneous assumption about margin requirements gives rise to the conclusion that the maximum achievable alpha from a fully invested long-short equitized strategy is 2.48 alpha. The current initial margin requirement for each equity position in a margin account, either long or short, is 50%. The theoretical maximum alpha achievable in a long-short strategy is thus 2. Given realistic constraints on futures margins and cash requirements, the practical maximum is 1.8.

Other Research Categories:

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(1) Presented in a CFA Institute webcast, September 2007, www.cfawebcasts.org/cpe/what.cfm?test_id=717. 2007 Financial Analysts Journal Graham & Dodd Award and Graham & Dodd Readers’ Choice Award winner. Included on the investment reading list of the Institute of Actuaries, UK, June 2008. Reprinted in Modern Portfolio Management: Active Long/Short 130/30 Equity Strategies, by Martin L. Leibowitz, Simon Emrich, and Anthony Bova, John Wiley & Sons, Hoboken, NJ, 2009.

(2) Presented at Goldman Sachs Equity Conference on “Remodeling the Investment Process – A Progress Report and Challenges Ahead,” September 2006. Featured in “New Approach Gets Hedge Fund Returns with Traditional Risk,” by Barry B. Burr, Pensions & Investments, June 12, 2006.

(3) Presented at the Institute for Quantitative Research in Finance (Q-Group) Seminar on “Long/Short Strategies in Equities and Fixed Income,” Fall 1995.

(4) Highlighted by Nobel laureate Bill Sharpe in Sharpe, Alexander and Bailey, Investments. 5th Edition, 1995.

(5) Required CFA reading.