The Structural Impact on Alpha
The Convergence Core Plus Strategy combines an active long portfolio with an active short portfolio, while maintaining a net long position to invested capital of 100% at all times. Viewed as a long/short strategy by some analysts and as a long equity strategy by others, we are often questioned on the reasoning behind the structure we have chosen. In simple terms, adding an active short investment process to our strategy has the potential to make a lot of money. But as we will demonstrate it is much more than that. In this paper we will look at the empirical evidence.
The Source of the Data
After years of working with clients as both portfolio managers and as equity analysts, we concluded that the traditional model was simply not working. In 2005 we opened a small hedge fund and started managing long/short. This fund was where we tested our ideas. For 5 years we worked on the development of our long/short process, and our proprietary dynamic model. At the end of December 2009 we rolled out our Core Plus Strategy. And while we are constantly researching improvements, the model we employ today is the model we rolled out over 3.5 years ago.
The data included in this paper represents the performance of the Strategy Composite over the past 3.5 years. All numbers are shown “gross,” to avoid assumptions regarding cost allocations between various components of the portfolio. We will provide an example of costs in a later section. All of the data presented is based on actual experience, but mirrors empirical research covering nearly 30 years.
The Convergence Strategy is built around the idea that there exist multiple sources of alpha that can be pursued in an equity portfolio. Under the traditional model, managers are constrained to “boxes.” Style purity is valued. The very notion of this model introduces a serious constraint, however. By boxing a manager, the advisor, by definition limits the source of alpha that a manager can pursue to “stock picking.” Historically very powerful, stock picking as a source of alpha has become more and more difficult as correlations within the equity market have risen. This evidence is straightforward: less than 30% of active managers have been able to beat their benchmark since the financial crisis.
The concept of “multiple alpha sources” is an extension of basic portfolio theory. If you are able to diversify your assets, you anticipate that your return pattern will be more consistent. Asset diversification is decision diversification. By building an allocation, the portfolio manager is making multiple decisions on the value and return potential of different asset groups. A poor decision, or a decision undermined by unanticipated events, will be mitigated by a series of other decisions being made in the portfolio. Our approach looks at stock picking as one source of alpha. Others include market cap tilt, beta tilt, valuation tilt… and of course shorting. If any one decision proves untimely, we rely on other decisions within the portfolio to, in effect, cover.
In 2011 over 80% of active managers lost to their benchmark.* Large cap, small cap, value, growth, and hedge fund managers all found it difficult to add alpha. Amongst other special circumstances surrounding 2011, stock picking simply did not work. Cheap stocks got cheaper. Shorting did work, however. In 2011, the Convergence Strategy Composite beat the Russell 3000 by over 300 basis points (gross) largely due to our ability to short.
In the context of classic portfolio construction, the portfolio manager adds an asset class to the allocation if it improves the risk adjusted return of the entire portfolio. Alternatives as a broad asset class have gained prominence within the portfolio due to the pursuit of higher risk adjusted returns. We will demonstrate that by adding “shorting” as an asset class within the long equity allocation, this is precisely what we have achieved.
In our opinion, the profession has experienced “objective drift” over the past 10 years. As the pursuit of higher risk adjusted returns heated up following the first stock market correction in 2000, the examination of alternative asset classes shifted from low correlations to the equity market, to low volatility. The push for “low volatility” became so predominant that an actual examination of the return potential of the asset in question became secondary, so long as it emulated “bond like returns.” Mathematically, there exists no added value to including an asset that has low volatility if its correlation to the return pattern of your existing portfolio is high. As correlations to the stock market rose within the alternative space, changing the relative mix became a linear function. Lower volatility is linear to lower returns. Lower volatility begets lower returns with no real impact on the risk adjusted returns potential of the portfolio.
The goal of reaching the efficient frontier can only be achieved if two conditions are met:
- The correlation of the return pattern of the asset in question to the existing portfolio is low.
- The asset being considered has an attractive risk return profile on its own. Please note, the asset in question may have a high risk/high return or a low risk/low return profile.
Alternatives and the Evaporation of Low Correlations
Markets are remarkably efficient. As more money pursues a particular objective, the relative advantage gets “arb-ed” away. Nowhere is this more evident than the hedge fund space. Consider the following:
Hedge funds are long the stock market. And as is evident in the chart, the trend is not cyclical, but rather secular.
If we narrow our focus to equity long/short and market neutral, the trend to high correlations is even more evident:
The bucket approach to asset allocation where long equity is grouped together and alternatives are grouped together will provide no true improvement in performance. To be sure, lower volatility is achieved but at a high cost and with no improvement in risk adjusted returns. The first test of low correlations has failed.
The Long/Short in the Core Plus Strategy
One method for examining the Core Plus Strategy is to bifurcate the long only allocation from the long/short within our Core Plus Composite. With 135% long and 35% short within the Core Plus Composite, we strip out the additional 35% long and match it to the 35% short and examine the return profile as a standalone long/short. This then allows us to compare the Convergence Long/Short within our composite to the universe of managers in the long/short space, and to examine whether the long/short “add on” is achieving the following objectives:
- Low correlation to the long only portfolio
- Added return
- Higher risk adjusted returns.
First consider the following:
The long/short portfolio within the Core Plus Composite has a negative correlation to the market.
Does the Asset Class Provide an Attractive Risk Return Profile on its Own?
The second test is whether the long/short is attractive in its own right. Here we look at the returns and the risk assumed within the long/short only and compare it to the universe of long/short managers.
Over the past 3.5 years, the long/short within the Core Plus Composite has produced a return of 7.2%, exceeding its direct comparison of the market neutral universe by 2.68 times. To achieve that return, we assumed 2.84 times the level of risk as measured by standard deviation. As a result, the Lipper Market Neutral Universe achieved a slightly higher Sharpe ratio. But to achieve that higher Sharpe ratio, the Market Neutral universe had to assume a correlation to the market of +.84. The Convergence Long/Short Composite was -.31. Adding a more volatile asset to a portfolio will improve the risk characteristics if the correlation is low or negative. The fact that the Convergence Long/Short Composite assumes more volatility is additive as long as the correlation remains low or negative.
Comparisons to the long/short universe are irrelevant. It is an underperforming category with high correlations.
Consistent Alpha Production
As noted earlier, the Convergence Core Plus Strategy is built around the idea that multiple sources of alpha exist within the equity space. By diversifying decisions, we increase the probability of producing an alpha more consistently throughout the cycle. Consistent alpha production will also lead to a more material alpha over time. To test this concept as it relates to adding the short portfolio, we look at the relationship between the alpha produced by our long portfolio over time and compare it to the contribution or alpha produced by adding the long/short component. Here are the stats:
In other words, there is essentially no correlation between when our long/short is adding value to the portfolio and when the long only is beating the Russell 3000. A diversified alpha.
Risk Models and Objectives
So why is the Convergence Long/Short so different? It all has to do with risk models and objectives. Earlier we discussed how “low volatility” had become an objective in and of itself. Particularly in the market neutral space, low volatility is a requirement. “Bond like returns” must be achieved if a manager has any hope of attracting investors. To achieve this goal nearly every long/short manager uses some form of prepackaged risk model such as Barra or Wilshire. Risk models are designed around minimizing tracking error, and tracking error can only be minimized if investments that your valuation model does not like are added or assigned a different weight in the portfolio. By placing a risk model over both the long and the short, you are able to minimize tracking error, but only at the expense of return. Further, the drop in the price of computing power made risk models accessible to all, and as money flowed into alternatives more and more players adopted their use. In our opinion, the risk based arbitrage in long/short is gone. The victim of its own success.
The long/short in the Convergence portfolio has a different objective. We are not seeking low volatility. In fact we want higher volatility as long as the correlation to the market and our long only alpha remains at zero or negative. This unconstrained view of long/short is precisely why it works, and why we married long only with long/short to provide a better overall solution.
Our Dynamic Model Revealed the Key
The Convergence Dynamic Model measures how investor preferences change over the market cycle. Early in our research we noted that preferences in the short portfolio were not the mirror image of the long portfolio. In other words, if investors were gravitating toward cheap stocks (low p/e, low price to cash flow, etc) in the long, it did not follow that expensive stocks were good shorts. In fact, we uncovered significant differences in our research between the drivers, or preferences, being rewarded in the long and the preferences being punished in the short, even within the same industry group. It occurred to us that the set of investors “creating” stock behavior in the traditional long space were not the same investors “creating” stock behavior in the short space. On the short side, our research revealed that preferences tend to be very narrow, time frames shorter, and patience nonexistent. Compare this to the traditional long only value manager who proclaims his time horizon on an investment is five years. From 2005 until we rolled out the Core Plus Strategy we researched independently the drivers of successful long portfolios and short portfolios. Our research concluded that the low correlation that we see between our long and our long/short is a direct result of these preferences or drivers being so different. There is a natural diversification that is achieved because of the different behavioral tendencies of these two different groups of investors. A natural diversification is achieved without the constraining and destructive effects of employing the ubiquitous risk model.
Long/short is expensive. At least when purchased separately. The average long/short market neutral mutual fund has an expense ratio of 1.9%, and the average long/short equity is 1.85%; and as noted above, all to generate a net return of 2.68% and 4.38% per year. In the so called 130/30 strategies, management fees, audit fees, and many administrative fees are calculated on the net long position only. In effect, the investor pays all of the associated fees imbedded in the expense ratio on the long portfolio, and receives the long/short extension for nominal incremental administrative and custody fees while avoiding additional management fees. The long/short extension does carry additional financing costs of approximately 30 bps per year, and extra trading costs of 50 bps per year; but these are costs all long/short portfolios must bear in addition to the expense ratios noted above. Keep in mind, the additional trading and financing costs only apply to the long/short portion of the portfolio. The impact on the total portfolio is in relation to the size of the long/short to the entire portfolio. The long/short extension in 130/30 strategies therefore provides all of the benefits noted above at little additional cost.
Let’s look at one example.
- $1,000,000 of investable capital
- Objective is to combine an investment in equity and long/short equity to achieve a lower overall beta.
- Two Choices
- Invest in a 130/30 Fund and Short Fixed Income. The investment in the 130/30 results in a 30% long/short position.
- Invest in a traditional long only equity fund and a long/short market neutral fund.
- The average Long Extension Fund costs 1.4% on the committed capital, equal to the long only portion.
- Traditional Long Only Fund: 1.00%
- Long/Short Market Neutral: 1.90%
- Short Fixed Income: .20%
By investing $650,000 in a long extension strategy, the investor picks up a long/short position equal to $227,500 or 35% of the invested capital at no additional explicit cost. The balance of investable capital is placed into short fixed income. The other option places $650,000 in a long only fund and the balance into a long/short fund. In both cases the investor assumes the risk associated with 65% of their money committed to the long equity market.
The result: The long extension option gives the investor essentially the same beta, but at a substantially lower cost.
Why Not Something Different?
We are often asked “why not market neutral” or “why not target a lower beta by changing the long/short ratio of the entire portfolio”? Such a change is very easy. The problem is that as you expose the long/short as a standalone strategy, all of the external objectives that have served to undermine the existing long/short space enter the picture. Suddenly “low volatility” takes center stage instead of “low correlation to the long equity portfolio.” Further, beta is fungible. While the Convergence portfolio is a one beta strategy, the alpha production is the key. Beta can be efficiently hedged to any target the investor desires.
Please note, we moved our long/short to 35% from 30% in the past year. This change is not based on market outlook, but rather the interplay between the long and long/short described in this paper.
The Convergence Core Plus Strategy marries a long only model with a long/short. To achieve this, we use a structure often maligned because of misperceptions, hype, and, frankly, poor execution. When 130/30 portfolios made their debut, they were overhyped as “the structure is the solution.” No structure is a solution. Execution matters. Through our research we were able to empirically measure that what drives a good long is not the mirror image of what drives a good short. Early practitioners failed to understand this simple, yet critical, component.
The structure, if utilized properly, provides an opportunity to marry two low correlated equity assets in a very cost efficient manner and achieve something increasingly rare: true alpha.
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