Achieving Alpha: How Do Traders Do It?
Quantitative vs. Fundamental Approach
Most active-extension funds are based on dispassionate, quantitative models that primarily track a portfolio's performance relative to indices and benchmarks. This is the approach taken at Boulder, Colo.-based Westpeak Global Advisors, according to head trader Christopher Ebel.
"We build models that we let pick the stocks rather than evaluating stocks on a one-by-one basis," Ebel relates. "It seems to be applicable to both fundamental and quantitative investing. But the quant base has the technology and infrastructure to hit the ground running, whereas the fundamental shops are more focused on individual stocks and bottom-up investing; quants look at the top-level, aggregate view of what's in the portfolio."
Quantitative managers already look at a portfolio's beta and its tracking error (deviation from the index's return), whereas there isn't a great deal of attention placed on such factors in fundamental shops, Ebel notes. Further, fundamental shops may need to add portfolio-optimization software and adjust their prime-brokerage relationships and order-management software, so there is a higher barrier to entry.
Also, the fundamental approach involves visiting with management and developing a discerning opinion about the potential performance of each security, a process that is time-consuming and geared toward buying shares that will appreciate steadily over time, adds Will Cazalet, director of long-short equity at AXA Rosenberg, which has run active-extension funds for about a year. "The burden of proof is largely on fundamental managers, in terms of starting an active-extension fund," Cazalet says. "The quant managers have less of a challenge in this respect. They have more naturally adaptive processes."
AXA Rosenberg deploys systematic investing, wherein a portfolio is rebalanced on a daily or weekly basis according to models, adds Cazalet, who says he prefers this method because "there is no emotion involved." For example, AXA Rosenberg does not visit with management of the companies. Despite the systematic strategy, however, Cazalet characterizes AXA Rosenberg's approach as more fundamental than quantitative.
"We reward companies that have superior earnings," Cazalet says. "We look at what the market as a whole pays for each component -- fixed assets, pension liabilities, goodwill, cash -- then there is the earnings forecast model out over a number of years. We are not comparable to a lot of quant firms that use factors such as earnings-to-price, momentum, relative strength, dividend yield and historical factors. We don't do that -- we are really more fundamental."
Appending this time-tested approach to the freedom to short stocks so far has paid off at AXA Rosenberg -- the firm forecasts its active-extension funds to deliver between 4 percent and 5 percent returns at the global level and 3.5 percent at the regional level. They have shown a composite 4.1 percent annualized return in their first year. "We're happy with that," Cazalet says.
SSgA also uses fundamental investing for many of its active-extension strategies because in the current competitive market, where today's proprietary algorithm is tomorrow's reverse-engineering feat, the fundamental approach "is always proprietary," according to the firm's Rockefeller. She concedes, however, that it is difficult for the entire fundamental investing team, including stock analysts, to operate a 130/30 fund that bases its strategies on "negative information" and buys stocks it thinks will decline in value. After all, Rockefeller says, these professionals are trained to build relationships and make long-term commitments to companies they believe in; something about shorting runs counter to that philosophy.
Shorting isn't the only cultural change on trading floors resulting from the increased pursuit of alpha. The nature of cooperation on the floor is evolving, as well.
Nicholas-Applegate set up an innovative program for running its 130/30s that has helped foster better communication among managers and traders on the floor, in addition to generating more alpha, says Kevin Chapman, the firm's head trader. If a 130/30 manager wants to short a security held elsewhere in the firm's inventory by another manager, the 130/30 manager must give the other manager 30 minutes' notice. "There could be names one likes and the other doesn't," Chapman explains. "It forces the managers to have a conversation about a security they have a difference of opinion on."
The system, mainly administered via E-mail, has other benefits, too. "That's also how we track things compliancewise," Chapman relates. "There could be a conflict of interest between the funds -- we have eliminated that problem by allowing questions to be asked. Someone on each fund team knows that one of her long holdings is shorted by someone else."
It seems the alpha-generation aspect has been working, for the most part. Nicholas-Applegate offers a 130/30 fund in global equities, initiated in January 2007; one in U.S. equity large caps, initiated in January 2007; and one in small caps, initiated in October 2006.
According to the company's 3Q 2007 report, its Global Equity 130/30 fund returned 11.4 percent, versus 3.6 percent for the MSCI ACWI (All Country World Index); the firm's Global Select fund, tracked to the same index, returned 5.8 percent. The U.S. Systematic Large Cap Growth 130/30 fund was up 8.2 percent, compared with 4.2 percent for the Russell 1000 Growth index. The U.S. Systematic Small-Mid Cap 130/30 fund returned -4.1 percent, versus -2.5 percent for the Russell 2500 (year-to-date, it was up 9 percent, versus 6 percent on the Russell).
Long-Short in for the Long Haul?
Although managers and traders appreciate active-extension funds for their ability to essentially fund good ideas by using negative information to identify bad investments, and many believe that interest in the vehicles will grow, there's no consensus on whether this and other, more adventurous strategies -- such as diversifying into emerging markets or trading more derivatives -- will blow away the buy-and-hold guys.
"We see 130/30 as a replacement for long-only because the beta is still 1 or close to 1; you're just taking on more active positions," AXA Rosenberg's Cazalet relates. "You create a much more efficient portfolio up to a certain point of leverage."
For SSgA's Rockefeller, however, the limitations of the active-extension approach are fairly evident. "We don't think it will replace the long-only fund. It tends to work best against benchmarks that have a capitalization skew -- for example, the S&P 500 has half its weight in the top 10 percent of its names," Rockefeller points out. But in small caps, it can be a hazardous strategy, she adds. Because there is less liquidity in these shares and they tend to be smaller in value on a per-share basis, the level of turnover -- and, thus, risk -- is necessarily higher when the need to sell arises, Rockefeller explains.
"With small cap, the increase in the amount of turnover causes a capacity constraint," adds Westpeak Global Advisors' Ebel. "Most of these funds, as a result, are being implemented in a large-cap environment."
And there are other risks inherent in the approach, as there are with any strategy that uses leverage. "Some managers short a concentrated portfolio of stocks," AXA Rosenberg's Cazalet says. "If you have the same 20 names in both [long and short] portfolios, if one name moves against you and you short it and it spikes up, it can really damage the portfolio. It is a counterintuitive set of behaviors -- if a long goes up, it makes money; if a short goes up, it is losing money for you." As a result, AXA and others diversify the short end of the portfolio more than the long, according to Cazalet, so that even if a price spikes in the short portfolio, it won't damage the entire portfolio significantly.
It's still too early to herald the active-extension model as the savior of alpha generation at traditionally long-only firms. At Nicholas-Applegate, for example, they are still only "seed funds," drawing off a combination of client and internal capital, according to the firm's Chapman. And at Westpeak, active-extension funds comprise just 15 percent of assets under management.
Although the quest for alpha itself is never-ending, savvy traders are taking this trend with a grain of salt, regarding active-extension as just another useful tool in an ever-expanding war chest.
"This is not the death of the long-only manager," says Westpeak's Ebel. "At the end of the day, if you have good performance, you don't need the flexibility of trading on the short side. [Active extension] is just kind of a growth area -- firms see this as a product that can bring in more revenue. But the market will get saturated, growth will stop and we will move on to the next thing."
Tweet This