Market neutral strategies phần 6 potx

Because of the tendency of the marks to offset, the equitized market neutral strategy does not require as large a liquidity buffer as the basic market neutral equity portfolio.. This res

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Exhibit 8.1 illustrates the deployment of capital for equitized struction This may be compared with Exhibit 3.1 in Chapter 3, whichEXHIBIT 8.1 Equitized Market Neutral Deployment of Capital (millions of dollars)

con-Source: Bruce I Jacobs and Kenneth N Levy, “The Long and Short on Short,” Journal of Investing (Spring 1997).

Long-c08.frm Page 133 Thursday, January 13, 2005 1:23 PM

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134 MARKET NEUTRAL STRATEGIES

illustrates the same for the basic market neutral equity strategy Here,again, we assume the investor deposits $10 million with the custodialprime broker Again, $9 million of the initial $10 million is used to pur-chase desired long positions, which are held at the prime broker Thisbroker also arranges to borrow $9 million in securities to be sold short.Upon their sale, the broker provides the $9 million in proceeds to thesecurities’ lenders as collateral for the shares borrowed.2

As with the market neutral equity strategy, the investor is subject toFederal Reserve Board Regulation T Under “Reg T,” which covers com-mon stock, convertible bonds, and equity mutual funds, the combinedvalue of long and short positions cannot exceed twice the value of theequity in an account.3 The investor must also retain a liquidity buffer Withthe equitized strategy, however, the investor must also purchase futures—

on the S&P 500, say—with a face value of $10 million As the futures can

be purchased on margin, the investor’s outlay will be about 5% of the facevalue purchased (or about $0.5 million in Treasury bills) This expenditurecomes out of the liquidity buffer, leaving it at a level of $0.5 million

As with the basic market neutral strategy, the shares borrowed tosell short must be fully collateralized If they increase in value, the inves-tor will have to arrange payment to the securities’ lenders so collateralcontinues to match the value of the shares shorted If the borrowedshares fall in value, the money will ﬂow in the opposite direction, withthe lenders releasing funds to the investor’s prime broker account Thesepayments ﬂow to and from the investor’s liquidity buffer daily

With an equitized strategy, however, the investor also experiencesmarks to market on the futures position These will tend to offset themarks to market on the shares borrowed An increase in the price of theshort positions induced by a rise in the overall market, for example,should be accompanied by an increase in the price of the futures con-tracts held long The marks to market on the futures can thus be used tooffset the marks to market on the shorts

This is illustrated in Exhibit 8.2 Here, we assume that the long andshort positions, as well as the futures position, double in value The inves-tor will now owe the securities’ lenders $9 million on the marks to market

on the borrowed shares But the investor’s account will also receive a $10million positive mark to market on the futures position The securities’lenders can be paid out of this $10 million, with $1 million left over

Of course, the futures position, having doubled its initial value, isnow undermargined by $0.5 million (assuming futures percentage mar-gins remain the same) Purchasing an additional $0.5 million in Treasurybills to meet the futures margin leaves the investor with $0.5 million.This is added to the liquidity buffer, which is now increased in line withthe value of the invested positions

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$20 + $1.0 in T

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The mechanics of equitized market neutral portfolio constructionthus differ from basic market neutral construction in the addition of thefutures position and the interaction between the marks to market on thefutures and on the short positions Because of the tendency of the marks

to offset, the equitized market neutral strategy does not require as large

a liquidity buffer as the basic market neutral equity portfolio In tion, the equitized portfolio is less likely to have to engage in trading inorder to meet marks to market on the borrowed shares

addi-Of course, the fundamental differences between the equitized andthe market neutral portfolios emerge in the differing responses of theirreturn and risk levels to movements in the underlying market These arediscussed below

Bull and Bear Markets

Exhibit 8.3 illustrates the performance of the equitized strategy in bothbull and bear markets This may be compared with Exhibit 3.2 in Chap-ter 3, which illustrates the same for the basic market neutral equitystrategy Again, we assume that the market either rises by 30% or falls

by 15%

First, it is evident that, unlike the market neutral portfolio, the tized market neutral portfolio does reﬂect market movements It has areturn of 35.4% in the bull market (versus 10.4% for the market neu-tral portfolio) and a return of –9.6% in the bear market (versus 10.4%for the market neutral portfolio) The return, and risk, associated withexposure to the broad equity market have been added back The portfo-lio can be expected to enjoy gains in bull markets and suffer losses inbear markets

equi-Perhaps less evident, but extremely important, is that the portfolioretains the value-added provided by market neutral construction Thelong-short spread of 5.4%, the same as in the market neutral case, adds

to the equitized portfolio’s return in the bull market and reduces theportfolio’s loss in the bear market This incremental return reflects theactive return to security selection, which benefits from the added flexi-bility market neutral construction offers in the pursuit of return andcontrol of risk (Of course, if the long positions in the market neutralportfolio had, contrary to expectations, underperformed the short posi-tions, the long-short spread would be negative, and the active returnfrom the market neutral portfolio would detract from the equitizedportfolio’s performance.)

This result underlines one of the major beneﬁts of market neutral folio construction and the gist of alpha transport—the transportability ofthe active return from the basic market neutral portfolio The active returnc08.frm Page 136 Thursday, January 13, 2005 1:23 PM

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on the market neutral portfolio represents a return to security selectionalone, independent of the overall return to the equity market from whichthe securities are selected This return reﬂects all the beneﬁts of marketneutral construction The equitized market neutral portfolio transportsthis return to the equity asset class, adding the security selection return(and its associated risk) to the equity market return (and its risk)

Uses of Alpha Transport

In the above example, the equity market exposure achieved via tives can be likened to a passive position in an equity index Institu-tional investors often seek passive exposures The popularity of passiveinvesting reﬂects in part the emergence in the 1980s of theories such asthe Efﬁcient Market Hypothesis and random asset pricing, whichimplied that active investing, including attempts to identify and exploitsecurity undervaluation (and overvaluation), were futile Perhaps evenmore important to the growth of passive investing was the accumulatingdata showing that active management generally failed to add value vis-à-vis underlying asset benchmarks, especially after management fees andtrading costs were taken into account.4

deriva-Passive portfolios, by contrast, demonstrated an ability to deliver on

a consistent basis performance comparable to representative assetclasses or subsets of asset classes But passive investing is insightless; itdoes not pursue alpha Furthermore, trading costs and managementfees, although modest, subtract from passive performance Combining amarket neutral portfolio, with an expected positive active return, and apassive exposure that reﬂects the risk and return of a desired benchmarkhas the potential to boost overall portfolio return without a substantialincrease in risk Given the size of most institutional portfolios, even a 1

or 2 percentage point return from security selection in the market tral portfolio can translate into large dollar gains, especially over time.Furthermore, the investor can choose to take a more aggressivestance toward benchmark positions For example, the investor canchoose to reduce (increase) derivatives positions if the underlying mar-ket is expected to decline (rise) This would incorporate an element ofmarket timing (and additional risk) into the market-neutral-plus-deriva-tives construct

neu-In Jacobs, Levy, and Starer, we explain how to optimize the utility

of a portfolio that combines a position in a desired benchmark withlong and short positions in benchmark securities.5 As with the marketneutral equity portfolio, the answer lies in integration: portfolio con-struction considers explicitly the risks and returns of the individualsecurities and the benchmark holding, as well as their correlations.c08.frm Page 138 Thursday, January 13, 2005 1:23 PM

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Transporting Alpha 139

TRANSFERRING ALPHA: MAXIMIZING SECURITY SELECTION

AND ASSET ALLOCATION

Over 90% of an average pension fund’s total return variance can betraced to its investment policy—the long-term allocation of its invest-ments across asset classes.6 Even within asset classes, the allocation of aportfolio across subsets of the asset class can explain a large portion ofthe portfolio’s return For 1985–1989, for example, over 97% of thereturns to a fund known for stock selection—Fidelity Magellan Fund—were mirrored by a passive fund invested in large-cap growth stocks(46%), median-sized stocks (31%), small-cap stocks (19%), and Euro-pean stocks (4%).7

Ideally, investors should be able to maximize both security selectionand asset allocation That is, they should be able to ﬁnd skilled manag-ers for each of the asset classes they choose to hold In practice, how-ever, the task of combining asset allocation with security selection ofteninvolves a tradeoff That is, the investor may be able to ﬁnd active man-agers who have demonstrated an ability to add value, but the universesexploited by these managers may not encompass the asset class desired

by the investor Given the presumed priority of the asset allocationchoice, it is often the return from security selection that is sacriﬁced.Consider the case of an investor who has both large-cap and small-cap equity managers On the one hand, to the extent that small-capstocks are less efﬁciently priced than their large-cap counterparts, thepotential of the small-cap manager to add value relative to an underly-ing small-cap universe may be greater than the potential of the large-capmanager to add value relative to an underlying large-cap universe Theinvestor may thus want to allocate more to the small-cap than the large-cap manager

On the other hand, small-cap stocks may be considered too risky ingeneral, or may be expected to underperform larger-cap stocks In theinterest of optimizing overall fund return and risk, the investor maywish to limit the allocation to the small-cap manager and allocate signif-icantly more to the large-cap manager In that case, however, the inves-tor sacrifices the potential alpha from small-cap security selection inexchange for overall asset class return and risk The investor’s asset allo-cation decision comes down to a choice between sacrificing securityselection return in favor of asset class performance and sacrificing assetclass performance in favor of security selection return

With alpha transport, investors need no longer face such Solomonicdecisions Market neutral portfolio construction techniques and deriva-tives can be used to liberate managers, and manager performance, fromtheir underlying asset classes Investors, or managers, can deploy deriva-c08.frm Page 139 Thursday, January 13, 2005 1:23 PM

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tives to transport the skill of any manager to any asset class Alphatransport enables the overall fund to add value from both asset andmanager allocation

An Equity-Based Example

The equity example in Exhibit 8.3 can be slightly modified to illustratemore clearly the very real flexibility advantages afforded by market neu-tral construction in conjunction with the use of derivatives to achieveexposure to a desired asset class Suppose this exhibit represents a mar-ket neutral investment in small-cap stocks The 6% long-short spreadthus represents the manager’s skill in selecting small-cap stocks Itreflects neither the return nor the risk of small-cap stocks in general.The manager can equitize this performance by purchasing futures

on the S&P 500, as described above.8 The manager can thus offer theperformance of the large-cap equity index, enhanced by the value-addedprovided by her ability to select small-cap stocks As long as this abilityleads to a positive long-short spread (as it does in Exhibit 8.3), it willincrease the return available from large-cap stocks when the index risesand reduce the loss when large-cap stocks fall

Now consider the advantages for an investor such as the one described

at the outset of this section This investor may be faced with having tochoose between the incremental returns expected from small-cap stocksand the lower risk afforded by a portfolio allocation to large-cap stocks

By choosing a market neutral small-cap portfolio equitized with large-capfutures, this investor can have his cake and eat it too He can retain theallocation to large-cap stocks while reaping the returns available fromsmall-cap selection The investor incurs no exposure to small-cap stocksper se, only to the selection skills of the small-cap manager

Alternatively, the investor can select a market neutral small-capmanager and establish a large-cap exposure by buying S&P 500 futureshimself, or by engaging another manager to implement derivatives over-lays Nor is the investor limited to small- or large-cap stocks, or even toequity, for that matter The investor can benefit from the skills of anymarket neutral manager, whatever the manager’s area of expertise, andestablish a desired exposure to virtually any asset class by using theappropriate derivatives The active return from a market neutral strat-egy that exploits convertible bonds, mortgage-backed securities, mergersituations, or sovereign fixed-income instruments can be transported viaderivatives to allow the investor to maximize the benefits from bothsecurity selection and asset allocation

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ALPHA TRANSPORT ABSENT MARKET NEUTRAL PORTFOLIOS

It should be acknowledged that investors can take advantage of the assetallocation freedom provided by derivatives without necessarily having toengage in market neutral investing To extend the example given above,suppose an active, long-only small-cap manager has been able to addvalue relative to the Russell 2000 small-cap universe, but that small-capstocks are expected to underperform large-cap stocks If an investormaintains an allocation to this small-cap manager, he will be giving upthe incremental return large-cap stocks are expected to offer relative tosmall-cap stocks But if the investor shifts funds from the small-cap to alarge-cap manager in order to capture the expected incremental assetclass return, he will be giving up the superior alpha from the small-capmanager’s ability to select securities within the small-cap universe.The investor, or the small-cap manager, can use derivatives to neu-tralize the portfolio’s exposure to small-cap stocks in general and thentransport any excess return (and residual risk) from the small-cap port-folio to the large-cap universe The incremental returns from both secu-rity selection and asset allocation are retained

In order to neutralize the portfolio’s exposure to the small-cap verse, the investor or the manager can sell short futures contracts on theRussell 2000 small-cap index, in an amount approximately equal to theportfolio’s value Changes in the value of the futures contracts will off-set the changes in the value of the portfolio in response to movements inthe small-cap universe underlying the futures The short derivativesposition thus removes the fund’s exposure to the small-cap universe.What remains is the differential between the portfolio’s return (and risk)and the small-cap universe return (and risk) represented by the index.This excess return, or alpha, and its associated residual risk, reﬂect themanager’s stock selection efforts

uni-Simultaneously, the investor or manager takes a long position infutures contracts on the S&P 500 This long derivatives position pro-vides exposure to the desired asset class, the large-cap equity universe.The investor can thus beneﬁt from any positive performance of thelarge-cap asset class while retaining the small-cap manager’s perfor-mance in excess of the small-cap universe The combined derivativespositions, one short and one long, effectively allow the investor to trans-port alpha from the underlying small-cap portfolio to the large-cap assetclass, just as the alpha from the market neutral portfolio was trans-ported via derivatives

As an alternative to the two futures trades, the investor can look tothe over-the-counter derivatives market, contracting with a swaps dealer

to exchange small-cap equity returns for large-cap equity returns Thec08.frm Page 141 Thursday, January 13, 2005 1:23 PM

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swap contract might specify, for example, that the investor pay terly over the term of the contract an amount equal to the return on theRussell 2000 index times an underlying notional amount—say the value

quar-of the underlying small-cap portfolio The swaps dealer pays inexchange an amount equal to the return on the S&P 500 times the value

of the portfolio

Consider, for example, a $10 million fund fully invested in an activesmall-cap portfolio Assume the Russell 2000 returns 10% over the period,the S&P 500 returns 13%, and the small-cap portfolio returns 12% Thesmall-cap portfolio grows from $10 million to $11.2 million The fund paysout 10% of $10 million, or $1 million, to the swaps dealer The fund receives13% of $10 million, or $1.3 million, from the dealer The fund winds upwith $11.5 million for the period It beneﬁts both from the superior return

on the large-cap asset class in excess of the small-cap asset class return andfrom the superior return of the active small-cap manager in excess of thesmall-cap asset class benchmark

An active equity portfolio’s value-added can even be transported to

a bond universe with the use of futures or swaps Futures contracts on

an appropriate equity index can be sold short to neutralize the lio’s equity exposure, while bond futures are simultaneously purchased

portfo-to establish the desired bond exposure Alternatively, the invesportfo-tor couldenter into a swap to pay an equity index return times a notional valueapproximating the value of the underlying equity portfolio and receive

an amount equal to a bond return times the portfolio value

Alpha transport can thus enable investors to capture incrementalreturns from active security selection, whether in the form of long-only

or market neutral portfolios, while maintaining the performance able from a desired asset allocation But alpha transport with long-onlyconstruction cannot benefit from the potentially considerable return-enhancing and risk-reducing advantages of market neutral portfolioconstruction While alpha transport affords flexibility in pursuit of returnand control of risk at the overall fund level, market neutral portfolio con-struction affords flexibility in pursuit of return and control of risk at theindividual portfolio level By improving the manager’s ability to imple-ment insights, market neutral construction can lead to better performancevis-à-vis long-only construction based on the same set of insights

avail-COSTS AND BENEFITS

An investor considering alpha transport should recognize some of theproblems that can arise An alpha transport strategy that involves ac08.frm Page 142 Thursday, January 13, 2005 1:23 PM

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market neutral portfolio, for example, may be subject to the related and leverage-related incremental risks and costs described inChapter 3 In addition, alpha transport strategies involving either mar-ket neutral or long-only portfolios may incur incremental risks or costsrelated to unexpected mismatches between the derivatives used fortransport and the asset class exposure desired

shorting-For example, alpha transport may be limited by the unavailability

or illiquidity of derivatives instruments In particular, futures contractsare not traded on all asset class benchmarks that may be of interest toinvestors, and even when available the contracts may not have enoughliquidity to support institutional-size needs While futures contracts onthe S&P 500 and U.S Treasury bond futures enjoy excellent liquidity,liquidity may drop off considerably for contracts on other indexes.When investors face insurmountable interference in transporting viafutures, however, they can turn to the OTC swaps market Swaps can becustomized to meet most investor needs

Furthermore, although the price of a futures contract will converge

to the price of the underlying instrument at expiration, futures-basedstrategies may not always provide the exact performance of the underly-ing index, for several reasons First, although futures are theoreticallypriced to reﬂect the current value of the underlying spot index adjustedfor the forward interest rate over the time to contract expiration and thevalue of dividends or interest on the underlying index, actual futuresprices can diverge from theoretical fair prices The most liquid futurescontracts usually track their underlying indexes closely, but less liquidcontracts tend to experience greater tracking error This type of basisrisk can add to or subtract from derivatives performance relative to theunderlying index

Futures performance may also differ from underlying index mance because of frictions introduced by margin costs and by the need

perfor-to roll over more liquid short-term futures contracts Because the chase or short sale of futures contracts involves a deposit of initial mar-gin (generally about 5% of the value of the underlying stocks) plus dailymarks to market, a small portion of investment funds will have to beretained in cash This will earn interest at the short-term rate, but willrepresent a drag on performance when the rate earned is below theinterest rate implicit in the futures contract In addition, the short rebatereceived on the proceeds of the short sales will generally be less than therate implicit in futures contracts Overall, the interest rate shortfall may

Swaps reduce some of the risks of missing the target index Swapsgenerally require no initial margin or deposit (although one may berequired by the terms of a speciﬁc swap contract) and the term of thec08.frm Page 143 Thursday, January 13, 2005 1:23 PM

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swap contract can be speciﬁed to match the investor’s horizon more, swap counterparties are obligated to exchange payments based onthe terms in the contract; payments are not subject to ﬂuctuations aboutthe value of the underlying benchmark, as is the case with futures.Swaps do entail price risk A swaps dealer will generally extract acharge in the form of a spread For example, an investor who wants toexchange the Russell 2000 return for the S&P 500 return may berequired to pay the Russell 2000 plus some basis points In general, theprice of a swap will depend upon the ease with which the swap dealercan hedge it If a swap dealer knows it can lay off a swap immediatelywith a counterparty demanding the other side, it will charge less than if

Further-it knows Further-it will have to incur the risks associated wFurther-ith hedging Further-its sure Swap prices may vary depending upon a speciﬁc dealer’s knowl-edge of potential counterparties, as well as its ability to exploit taxadvantages and access to particular markets

expo-Swaps also entail credit risk expo-Swaps are not backed, as are futurescontracts, by exchange clearinghouses The absence of initial margindeposit and daily marking to market further increases credit risk.Although credit risk will generally be minimal for the investor or man-ager swapping with a large investment bank (or the well-capitalizedsubsidiary of such a bank), the credit quality of counterparties must beclosely monitored to minimize exposure to potential default.10 Defaultmay prove costly, and as swaps are essentially illiquid, it may be difﬁcult

or impossible to find a replacement for a defaulting counterparty.The potential benefits of alpha transport, in terms of flexibility andvalue-added, are nevertheless substantial for both investors and manag-ers The decision to maximize alpha need no longer be subservient tothe investor’s asset allocation decision The investor can pursue the bestopportunities in both asset allocation and security selection

Alpha transport may also liberate portfolio managers This will tainly be the case if managers have neglected their own areas of exper-tise in order to pursue returns from those types of securities favored byclients Alpha transport frees managers to focus on the universes withinwhich they feel they have the greatest skill, hence the greatest potential

cer-to add value This freedom should ultimately translate incer-to enhancedperformance for their clients

Finally, managers and investors unfamiliar with market neutralinvesting and unaccustomed to derivatives may view the whole idea asjust too complicated In fact, however, alpha transport affords investorsincreased ease and ﬂexibility in structuring an overall fund By decou-pling the security selection decision from the asset allocation decision, itallows these key elements of portfolio performance to be recombined tosuit any investor needs

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NOTES

1 Alpha transport is becoming increasingly popular among investors and managers.

See Bruce I Jacobs and Kenneth N Levy, “Alpha Transport with Derivatives,” nal of Portfolio Management, May 1999; and James Rutter, “How to Make Volatil- ity Pay—The Next Step Forward Could Be Portable Alpha,” Global Investor, June

Further-to much less stringent requirements than Reg T, and hedge funds and other invesFurther-tors may organize as their own broker-dealer or arrange to trade as the proprietary account of a broker-dealer in order to attain much more leverage than Reg T would allow See Bruce I Jacobs, Kenneth N Levy, and Harry M Markowitz, “Portfolio Optimization with Factors, Scenarios and Realistic Short Positions,” forthcoming,

Operations Research.

4 See Bruce I Jacobs and Kenneth N Levy, Equity Management: Quantitative ysis for Stock Selection (New York: McGraw-Hill, 2000).

Anal-5 Bruce I Jacobs, Kenneth N Levy, and David Starer, “Long-Short Portfolio

Man-agement: An Integrated Approach,” Journal of Portfolio Management, Summer

1999.

6 Gary P Brinson, Brian D Singer, and Gilbert L Beebower, “Determinants of

Port-folio Performance II: An Update,” Financial Analysts Journal, May/June 1991.

7 William F Sharpe, “Asset Allocation: Management Style and Performance

Mea-surement,” Journal of Portfolio Management, Winter 1992.

8 One might think Exchange Traded Funds (ETFs) would provide an alternative to futures, as they also offer exposure to various market index benchmarks However, they are subject to Reg T margin requirements, hence establishing a given position in ETFs requires substantially more funds (some 10 times more) than establishing a comparable position in futures

9 The investor may have some room for negotiation in the investment of the short sale proceeds Typically, overnight rates are pegged to Fed funds, LIBOR, or broker call, but the funds may be committed for longer terms at higher rates Investment for long-

er terms will subject the proceeds to interest rate risk if the performance benchmark

is linked to a floating rate, but it may reduce risk for an equitized market neutral folio (for instance, if the maturity of the investment matches that of the stock index futures contracts used as an overlay on the portfolio).

port-10 And, as recent examples such as Enron and WorldCom show, relying on credit ing agencies is not necessarily sufficient.

rat-c08.frm Page 145 Thursday, January 13, 2005 1:23 PM

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Kenneth N Levy, CFA

PrincipalJacobs Levy Equity Management

wo spectacular blowups in the 1990s marred the reputation of marketneutral investing The failure of Askin Capital Management in 1994and the collapse of Long-Term Capital Management in 1998 cost theirinvestors hundreds of millions of dollars, roiled the ﬁnancial markets,and led many to question the legitimacy of market neutral strategies Wediscuss each case below—what happened, the extent to which blame can

be laid at the feet of market neutral investing as a strategy, and the sons to be learned

les-ASKIN CAPITAL MANAGEMENT

In April 1994, Askin Capital Management (ACM) ﬁled for bankruptcy.David Askin had assumed control of two hedge funds, Granite Partners(a limited partnership) and Granite Corporation (a Cayman Islands cor-poration), in January 1993 He had managed the funds for their previ-ous owner since September 1991 Prior to that, Askin had worked inﬁxed income at Drexel Burnham Lambert and Daiwa Securities, where

T

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