130/30 Strategies as Expensive Beta

Only a few years ago, 130/30 funds were all the rage. They allowed equity managers who had traditionally been bound to a long-only strategy to make use of short exposure to shape their portfolios. The ability to take short and levered long positions was supposed to reduce the overall riskiness of the portfolio and also to provide new ways to beat the benchmarks, e.g. by adding long exposure to the best stocks in a sector and taking short positions in the worst.

In “The Credit Suisse 130/30 Index: A Summary and Performance Comparison,” Jasmina Hasanhodzic, Andrew W. Lo, and Pankaj N. Patel discuss a 130/30 benchmark that is intended to show how these sorts of strategies can beat traditional passive indexing. “[T]he magnitude of the performance drag” from long-only constraints is, in their words, “difficult to measure without a proper benchmark for a 130/30 portfolio.” Their benchmark ranks stocks using familiar factors based on value, momentum, size, technical levels, earnings growth, etc. The back-tested results looked great:

A comparison of the cumulative returns of the Credit Suisse 130/30 Investable Index and other indexes, January 1996 – September 2007. Source: Hasanhodzic, Lo, and Patel.

The out of sample performance available when the paper was written covered one of the worst periods in recent market history, so we shouldn’t jump to conclusions about the effectiveness of 130/30 factor strategies. In fact, the CS 130/30 index performed as intended, beating the passive indexes in terms of both performance and riskiness.

A comparison of the cumulative returns of the Credit Suisse 130/30 Index (Gross) and various other indexes, October 2007 – December 2008. Source: Hasanhodzic, Lo, and Patel.

An ETF was launched, the ProShares Credit Suisse 130/30 (CSM), making this an investable index, and with a few more years of distance from the financial crisis, we can look at how well this index has done at it’s stated goal: again, to demonstrate why the long-only constraint on fund managers creates a meaningful drag on performance.

CSM and SPY Returns, July 2009 – December 2012. Source: Yahoo!

Since the fund was launched, it has actually underperformed the SPY ETF slightly, and with a correlation of 0.97, making CSM nothing but an expensive index proxy. The fund has done its job; it just seems that the thesis of the 130/30 strategy has been wrong over this period.

[h/t @gappy3000 for the pointer]

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