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Taking a More Relaxed Approach

Active equity portfolios are typically managed with a ‘long-only’ constraint. Under this restriction, the minimum exposure to any stock is zero and this precludes holding negative exposures to a company’s shares. As a result, the size of active ‘underweight’ positions is often constrained by the weight of a security in the fund’s benchmark index. Therefore, in a long-only portfolio, the ability to fully express investment insights in the actual portfolio is hampered as it is not possible for the fund manager to take meaningful underweight positions in stocks that they do not like. This reduces the potential to deliver outperformance to clients, which can be seen as a loss of efficiency.

An example of the long-only constraint in action is evident when we look at the effect of a capitalisation-weighted benchmark on portfolio construction. In this sort of index, each stock’s weighting in the benchmark is determined by its market value (the number of shares in issue, multiplied by the share price).

Figure 1: MSCI Europe benchmark weights

Source: MSCI, June 2006

The structure of large cap benchmarks, such as the MSCI Europe Index, creates portfolio construction challenges as 50% of the weight of the index by market cap is composed of approximately the first 45 stocks. For some active funds, active positions in long-only portfolios may be limited to +/-1% of the benchmark weight. If we use the MSCI Europe Index as our benchmark, it gives us the opportunity to potentially overweight any of those names by 1%. But as only 18 companies have an index weight of 1% or more, the manager can only take advantage of negative information to fully underweight these 18 stocks. They are unable to take maximum advantage of negative return forecasts on the remaining 566 stocks, because the most extreme position allowed is to hold zero.

To overcome these constraints, investors can look to long/short strategies, but many may be reluctant to take the plunge because of their investment philosophy or scheme guidelines. Fortunately, it is possible to achieve much of the efficiency gain accessible to long/short investors by allowing ‘partial shorting’.

Relaxing the long-only constraint

Fund managers and pension plans have traditionally overcome the loss of efficiency that results from adhering to a long-only constraint by investing in either low-risk equity strategies or long/short strategies. A long/short strategy is allowed to hold overweight (long) positions in a stock, as well as fully express negative views through holding ‘short’ positions.

To implement a short position, the investment manager effectively sells a security that the portfolio does not own. This will be motivated by the view that the stock is likely to fall in value, allowing the ‘short seller’ to buy the security back at a lower cost than the price at which they sold it. A short position will make a profit for the seller if the security declines in price.

More recently, there has been interest in the significant efficiency gains that can be made from partial, rather than complete, relaxation of the long-only constraint.

The long-only constraint in action

Figure 2 shows that the ‘active return’ (portfolio return relative to benchmark return) delivered on a long-only portfolio does not increase on a one-for-one basis as we take more ‘active risk’ (portfolio risk relative to benchmark risk), but gradually tapers off. This loss of efficiency (as the active risk of the portfolio increases) is a result of the long-only constraint. Efficiency is quantified by the ‘information ratio’ (IR) which is the additional return per unit of risk taken. Portfolios become less efficient (being less able to capture negative investment opinions) resulting in lower IR.

Figure 2: Impact of long-only constraint

Source: Barclays Global Investors

We can see how long-only portfolios begin to lose some of their efficiency compared to long/short portfolios by examining a refinement to Grinold and Kahn’s Fundamental Law of Active Management (Active Portfolio Management: A Quantitative Approach for Producing Superior Returns and Controlling Risk: Richard Grinold & Ronald Kahn). It describes the relationship between the IR of a portfolio (its efficiency), the ability to fully implement investment insights (transfer coefficient or TC), the skill of the manager (information coefficient or IC) and the number of active positions that the manager can make.

Stronger relationships (higher transfer coefficients) exist between long/short managers’ return forecasts and their positions, as they can implement positive and negative views to the same degree.

Positive forecasts of a company’s prospects lead to long positions, while negative forecasts result in short positions. Long-only managers have typically lower transfer coefficients due to the inability to take short positions. Their negative forecasts of company prospects can at most be implemented through a zero weight in such portfolios, lowering the correlation of return forecasts to active weights.

Of course, investment managers who cannot systematically apply their investment insights to every stock in their benchmark cannot take full advantage when the long-only constraint is lifted. For example, a manager who has only focused on buys and only has enough resources to research 30–50 stocks to purchase is unlikely to have any negative information to short stocks.

Partial shorting

Partial shorting creates a portfolio that differs from a traditional long-only portfolio in that it has some leeway to short stocks. Figure 3 gives an example of such a strategy, in this case a 120/20 strategy, but we could equally look at 130/30, or 140/40.

Figure 3: Strategy implementation

Source: Barclays Global Investors

In this example, we take a client contribution of £100 million, borrow and then sell short unattractive securities worth 20% of the contribution (£20 million). With the proceeds of £20 million from selling these assets short and the original £100 million contribution, we would invest £120 million in long positions, in companies that we believe are attractive compared to their peers. This achieves our desired portfolio of a 120% long portfolio, combined with our 20% short portfolio. The portfolio is designed to remain fully exposed to the underlying market, while adding to the breath of opportunities because we can express our negative views on stocks to a larger degree.

A stock example

To better illustrate the efficiency gains possible with the partial shorting portfolio compared to a long-only portfolio, it is helpful to compare active holdings in Company A and Company B across the two strategies, as shown in Figure 4. Here we assume Company A and Company B are in the same industry, and have similar risk characteristics.

The most obvious differences occur on the underweight side for names on which we have negative views. The first group of bars in the chart show our active position in Company A, which has a relatively small benchmark weight of 0.10%. In our long-only portfolio, we cannot utilise our negative information on the name by taking a large active underweight position because of the long-only constraint. The largest underweight position we can take on this name is -0.10% underweight (i.e. not holding the stock).

The 120/20 strategy has greater freedom to act on this negative view and has taken a short position of -0.80%. On the long side of both strategies, we see similar positioning for Company B, a name that has a very positive ranking according to the manager’s insights and has a weighting of approximately 0.47% in the index. In a long-only portfolio, this name is about 0.55% overweight relative to its benchmark weight. In the 120/20 portfolio, Company B has a similar, but slightly higher active position of 0.75% overweight.

Figure 4: Portfolio positions

Source: Barclays Global Investors

This example highlights two areas in which the partial shorting strategy can more efficiently use investment insights on the long and short side of the portfolio. The following areas increase the breadth, or number of names, in which the portfolio can take positions:

• Greater efficiency occurs on the short-side as the portfolio is now allowed increased underweight positions
• The partial shorting portfolio is able to take larger positive active positions (of course within guideline bounds for active weights) on the long-side

Positive active positions are implemented when there is a stock on the short side with similar risk characteristics, which can be used to appropriately hedge the long position. This is evident by the slightly higher active weight of the partial shorting strategy in Company B. The chart below shows the benefits of this increased efficiency on active performance.

Figure 5: Example Cumulative contribution to specific return

Source: Barclays Global Investors. For illustration purposes only.

Conclusion

The removal of the long-only constraint to allow partial-shorting leads to improved performance, as it enhances the manager’s ability to implement their investment insights efficiently.

These strategies are gaining greater acceptance and seeing increasing interest, particularly among investors who may be uncomfortable with full long/short strategies for a number of reasons.

We expect to see the market for partial shorting strategies develop rapidly over the coming year, as a variety of new products come to market and as trustees learn more about these new strategies.