20 Myths about Enhanced Active 120–20 Strategies

Enhanced active equity strategies, including 120–20 and 130–30 long–short portfolios, have become increasingly popular as managers and investors search for new ways to expand the alpha opportunities available from active management. But these strategies are not always well understood by the financial community. How do such strategies increase investors’ flexibility both to underweight and to overweight securities? How do they compare with market-neutral long–short strategies? Are they significantly riskier than traditional, long-only strategies because they use short positions and leverage? This article sheds light on some common myths regarding enhanced active equity strategies.Enhanced active equity strategies, including 120–20 and 130–30 portfolios, have become increasingly popular as managers and investors search for new ways to expand the alpha opportunities available from active management. Enhanced active portfolios have short positions equal to some percentage of capital (generally 20 percent or 30 percent but possibly 100 percent or more) and an equal percentage of leveraged long positions. They are facilitated by modern prime brokerage structures, which allow the proceeds from short sales to be used to purchase long equity positions.Enhanced active equity strategies differ in some fundamental ways from other active equity strategies, both long-only and long–short strategies. As a result, the financial community has formed some misconceptions about these strategies.Some investors think, for example, that allowing a portfolio to sell short offers little incremental advantage over long-only portfolios. But an active long-only portfolio, although it can overweight any security by enough to achieve a significant positive active weight, cannot underweight many securities by enough to achieve significant negative active weights. Only about 15 stocks in the Standard & Poor’s 500, Russell 1000, or Russell 3000 indices have index weights greater than 1 percent. Thus, meaningful underweights of many securities can be achieved only if short selling is allowed.Other investors believe that constraints on short selling do not affect a portfolio’s ability to overweight attractive securities. But a 120–20 portfolio can sell short and use the proceeds to purchase additional long positions, thereby taking more and/or larger active overweight positions than a long-only portfolio can take with the same amount of capital. Furthermore, the incremental overweights and underweights permit more diversification than a long-only portfolio allows, which should result in greater consistency of performance. Moreover, and more subtly, the long-only portfolio manager may not be able to establish desired overweights in some attractive securities because without short selling, related securities cannot be underweighted by enough to counterbalance the risk exposures that would be created by the overweights.Some investors might think that an enhanced active equity portfolio offers less flexibility to overweight and underweight securities than an equitized market-neutral long–short portfolio, which has fully active weights through its market-neutral portion and full exposure to the equity market through an overlay. It can be shown, however, that enhanced active and equitized market-neutral portfolios are equivalent, with identical active weights and identical market exposure. The enhanced active portfolio is more compact, however, and uses less leverage than the equitized portfolio. Furthermore, because it obtains its market exposure with individual security positions, it can attain exposures to benchmarks even if liquid overlays are not available.Enhanced active equity portfolios are sometimes portrayed as much more risky than long-only portfolios because they contain short positions. But whether a portfolio achieves an underweight by holding a security at less than the security’s benchmark weight or by not holding the security at all or whether it extends the underweight by selling the security short, the portfolio is in a risky position in terms of potential value added or lost relative to the benchmark. And although losses on short positions are theoretically unlimited, because a security’s price can rise without limit, this risk can be minimized in practice by diversification and rebalancing.Finally, some confusion exists as to where enhanced active strategies fit in an asset allocation framework. Enhanced active portfolios share some characteristics with hedge funds and other alternative investments. They have the same equity benchmarks as comparable long-only portfolios, however, while enjoying the potential of improving upon the performance of long-only portfolios by virtue of their ability to extend portfolio overweights and underweights. They are thus an enhanced form of active equity management.