While reading “Challenges in Quantitative Equity Management” from the Research Foundation of the CFA Institute, I came across this concept, related to 130/30 funds, mentioned several times; in fact, mentioned often enough to get on my nerves:

In theory, these strategies are a long-only fund plus a zero-capital long-short overlay.

Bullshit, bullshit, bullshit.

Did I say “bullshit?” Yes, at least as these funds are commonly implemented.

The common tack is for the fund to use one (1!) factor model to “score” each stock, then use a covariance matrix to weight the holdings. Since only one model is used, the 100% long component and the 30% additional leveraged long component have a very strong correlation to each other. Additionally, the 30% short component has a pretty strong inverse correlation to the long components. In reality, as commonly executed, 130/30 is just one frickin’ leveraged strategy.

OK, I’m overstating the case just a bit, as there is some diversification benefit, but it’s not as much as it could be. That diversification benefit comes pretty much entirely from the short side, because to the extent that they add positions on the long side (and increase diversification there), they also dilute the impact of their factor models (because they’re taking the top-scoring 350 or so stocks, instead of the top-scoring 200 or so stocks), so it comes out in the wash. It may be better to simply leverage the existing 100% long component instead of adding additional stocks for the extra 30% component (something to think about).

Now imagine three different factor models, one that works best on the short side, and two that work best on the long side. Take the best-returning long side model and put it at 100% weight, then put the others at 30% weight apiece. Now one would get a true, large diversification benefit, whereas there’s much less diversification benefit when the same model is used to define all segments.

Of course, if all three models aren’t on the same order of magnitude in terms of returns, then we potentially have another dilution problem … adding a diversifying strategy that compounds at 6% annually to a main strategy that compounds at 20% annually doesn’t necessarily help the situation, as the manager may be better off in the long run being non-diversified and compounding faster.

My second gripe on the above quoted idea is the assertion that the long-short extension is “zero-capital.” No it ain’t. Leverage costs money, and even if the cost is smaller for a fund than for a retail hack like myself, there are other costs to leverage. First, it exacerbates the impact of any heteroscedascity of returns that the manager hasn’t accounted for; second, it leaves the manager at the mercy of the general availability of leverage in the credit marketplace; third, it introduces a credit risk from the specific counterparty providing the leverage. While it may tie up less capital, it increases risk*, and that needs to be accounted for somehow. To their credit, they do mention leverage as a problem:

Theoretically, the advantage of this strategy is obvious: If the long-short strategy is profitable, it is a zero-cost contribution to returns with no capital invested. In practice, however, there might be two problems: (1) The strategy is leveraged, and (2) it is very sensitive to the quality of the forecasts used for shorting.

An additional gripe on the ideas inherent in 1X0/X0 discussions is the assertion that the strategy will have “beta of 1 to the market” - this is “beta bullshit” that I have already addressed in another post. Beta could be high or low, depending on the factor models used.

The point is that, generally speaking, the generally accepted assumptions used in portfolio management by Wall Streeters probably shouldn’t be.

* Don’t for damn second think that “risk” is solely defined by volatility of returns! There are lots of different kinds of “risk” … risk of ruin (often worse in “low-vol” leveraged strategies than in high-vol unleveraged strategies), risk of not achieving a benchmark return, etc.

I’ve written about diversification and strategy blends before.
I’ve written about 130/30 before.
I’ve used a research paper to put together an example long/short trading system.

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