Our survey of hedge fund strategies continues. Intermediate between long/short equity hedging and equity hedged market neutral is a fairly recent innovation: enhanced active 100X –X (EA). As briefly mentioned last time, an EA portfolio has the following characteristics:

• Contains short positions equal to some percentage of the book (X, generally 20 percent or 30 percent but possibly more) and an equal percentage (100 + X) of leveraged long positions.
• Relies on prime brokerage structures, include security lending, that allow short proceeds to purchase long positions without additional margin.
• Makes use of quantitative techniques to actively manage selection, timing, and hedging ratios.

For example, a hedge fund manager allocates a percentage of his/her capital, say 30%, to short positions, and then uses the proceeds from the short sales to put on a long position equaling 100% plus the amount shorted – in this case giving a total long position of 130%.  This example would be called an enhanced active 130-30 strategy.   Note that the offsetting long and short positions leaves the portfolio with the same beta it would have with just a 100% long investment, but with a measure of downside protection not available in the long-only strategy.  Theoretically then, if the fund manager can differentiate strong and weak stocks, the 130-30 portfolio should outperform its 100-0 counterpart due to equal upside potential but decreased downside risk.

When a fund manager is competing against a benchmark, the enhanced active strategy provides greater flexibility to underweight weak stock and overweight strong stocks compared to long-only strategies. This is because the EA fund manager can achieve through shorting an underweight less than zero, which is the minimum weight in a long-only strategy. There is evidence that a stock is more likely to be overvalued rather than undervalued; hence underweighting should be more valuable than overweighting, and since underweighting is easier using an EA strategy as compared to using a long-only one, EA should have better returns (i.e. less risk).

Note that, given appropriate leverage flexibility, an EA 200-100 strategy would have $3 (300%) invested for each $1 (100%) of capital. This differs, however from the more traditional equity hedged market neutral strategy, which would invest equal amounts (3 x 100%) in long, short, and benchmark positions. That’s because the 100% invested in the benchmark, although providing market beta, is inflexible, and hence a potential drag on return. In contrast, the EA 200-100 has complete flexibility in portfolio selection, and thus affords fund managers an opportunity to “strut their alpha” (assuming they have any). Parenthetically, since the EA strategy uses short proceeds for additional leverage, it does not trigger Unrelated Business Taxable Income (UBTI) tax liabilities; in contrast, using margin to increase leverage will engender UBTI taxes.

Normally, SEC Regulation T prohibits leverage to 150% of capital, but through security-lending techniques available from prime brokers, this problem can be sidestepped. Prime brokers also facilitate EA strategies by allowing long positions to satisfy the maintenance margin requirements for short positions – no additional cash or security collateral is needed. Instead, the broker will charge a stock loan fee to cover its costs.  Dividends received will normally exceed dividends owed, so ultimately there is little need to tie up cash with an EA strategy.

One risk encountered in any long/short portfolio but absent from a long-only one is unlimited upside on a shorted stock.  A long position can only go to zero if a stock tanks; there is no limit on the loss caused by a short position on a skyrocketing stock unless the portfolio is actively managed and balanced. Because short positions have this additional risk factor, long/short portfolios should have access to a systematic (beta) risk premium, and hence greater average returns, than their long-only brethren. Of course, this additional risk is somewhat offset by decreased downside risk on long positions. The net effect is situationally-dependent.

Commissions are typically higher in EA portfolios relative to long-only ones, due to higher balancing activity in the former.  The ultimate test of an EA strategy, and its manager, is whether it nets, after fees and commissions, an alpha return (above-market return on a risk-adjusted basis), and does it do so year-in, year-out. We view this with a skeptical eye, and will continue that viewpoint as we next move our discussion to hedged market neutral strategies.