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We believe extension approaches may:
We cannot think of many competitive endeavors in which doing next to nothing turns out to be a winning strategy. Since the global financial crisis (GFC), a passive approach to US large-cap equities has been one of them. Over the 10 years through December 2021, the S&P 500 Index had an impressive track record1:
The last two points were not lost on institutional investors, many of whom gave up on active management of US equities and focused their attention (as well as risk and fee budgets) elsewhere. But the first two points above are also relevant. The extraordinary outperformance of US large-cap equity beta helped many investors with diversified asset allocations achieve their overall return targets and made alpha generation less important.
Since the end of 2021, however, global markets have experienced significant shifts as asset prices have adjusted to a new interest-rate regime driven by higher inflation and an economy that looks quite different in the wake of the pandemic. In 2022, the S&P 500 fell nearly 20%, and while the market has rebounded in 2023, leadership has been narrow and dispersion within sectors has been significant.
As investors come to grips with the notion that equity market returns may be lower and volatility higher than during the post-GFC period, there is growing interest in increasing capital efficiency across the entirety of an investment lineup. In a world of single-digit equity returns, 150 – 200 basis points (bps) of alpha would represent a more significant portion of a portfolio’s total return. In the 80 years leading up to the onset of quantitative easing, this was indeed the world in which we lived: Over rolling three-year periods, the S&P 500 generated an average annualized return of 8%.2
With this as a backdrop, we turn to the focus of this paper: What can institutional investors do to potentially improve the odds of generating a meaningful level of alpha in core US equities, especially in light of the relative efficiency of this asset class? In a previous paper, we recommended that investors consider extension strategies as a way of capturing the alpha potential of less-efficient mid- and small-cap stocks while maintaining the risk profile of a core large-cap strategy. Here we share details on how extension strategies may help improve portfolio construction flexibility and risk-adjusted returns.
Extension strategies (often referred to as 130/30 or 140/40 strategies) are similar to traditional long-only approaches. Their objective is to outperform a benchmark while maintaining a moderate level of tracking risk, consistent with a core equity profile. The primary difference is that an extension manager has additional flexibility to short stocks. Capital generated from shorting is fully invested in additional exposure on the long side, maintaining net exposure of 100% and producing the symmetry of the gross leverage (30/30, 40/40, etc.).
As this structure implies, beta is typically maintained very close to one. This is an important distinction between extension strategies and traditional long/short equity hedge funds, most of which maintain net exposures below 100% and betas below one, and do not focus on traditional benchmarks.
We think the ability to short stocks (and generate additional long capital) provides extension managers with several important degrees of additional flexibility for outperforming a benchmark. First, the ability to short significantly expands the range of opportunities to underweight stocks. In a long-only portfolio, a manager is limited to underweighting only stocks that are included in the benchmark, and the size of their underweights is constrained to the size of the stock in the benchmark. Thus, while underweights represent, by definition, half of a manager’s active exposure, their profile is heavily influenced by the benchmark’s capitalization profile.
To illustrate, Figure 1 shows the weights of individual stocks in the S&P 500 Index, from largest to smallest capitalization. The implications for sizing underweight positions are notable:
For long-only managers who focus their research across the market-cap spectrum, the ability to express negative views is constrained to only the largest-cap stocks in the benchmark, despite the greater dispersion and inefficiency typically found further down the cap spectrum. Consequently, the majority of a portfolio’s underweight positions are typically concentrated in a relatively small number of large-cap stocks.
Many long-only managers still choose to own mid- and small-cap stocks. Doing so, however, introduces a smaller-cap tilt to the portfolio, as underweights are necessarily concentrated in larger-cap stocks. As a result, the potential for stock selection to add value is limited to overweights and may be offset to some extent (positively or negatively) by the impact of the market-cap tilt.
Allowing a manager to short changes the landscape. Extension strategies may give managers flexibility to underweight positions based on conviction rather than market cap, and to potentially take greater advantage of price dispersion in mid- and small-cap stocks without introducing a market-cap tilt to the overall portfolio. Underweights do not need to be concentrated in only the largest-cap stocks; they can be more evenly distributed across large-, mid-, and small-cap ranges.
An additional implication is that short positions in an extended portfolio tend to be tilted toward mid- and small-cap stocks because larger-cap stocks can be underweighted just by not owning them. Both points have important implications for the overall risk profile of a typical extension strategy, which we address below.
The second degree of flexibility offered by an extension structure comes from the additional capital generated by short positions, which is invested in additional exposure on the long side. Portfolio managers have several options for deploying this additional capital:
In our research into extension strategies, we find that managers tend to emphasize the first two options. Most often, the additional capital raised through shorting is used to add more mid- and small-cap stocks. These overweights, combined with short positions, significantly increase portfolios’ exposures to stock-selection opportunities in higher-dispersion, less-efficient segments of the market.
Managers also can use the additional long capital to neutralize lower-conviction benchmark positions, allowing more precision in conviction-weighting bets among large-cap stocks. Because shorting a stock adds proportionately to active share, using that capital to neutralize a benchmark position results in no loss of active share. Instead, the active share can be shifted down the capitalization range to ideas where a manager may have higher conviction.
Despite investing more capital in mid- and small-cap stocks, extension strategies tend to avoid a small-cap tilt due to the profile of shorts. Because managers can underweight a larger-cap stock by not owning it, short positions tend to be skewed toward mid- and small-cap stocks. Taken together, the overweight (long) and underweight (short) positions in mid- and small-cap stocks generally balance each other out, producing a market-cap profile that is more neutral to the benchmark. However, the portfolio can potentially benefit from significant active exposure across the market-cap spectrum.
An important implication of greater flexibility to over- and underweight stocks is higher active share. By definition, any short position contributes directly to active share. In addition, expanding the number of overweight positions also adds to active share. Yet, the additional active share does not necessarily generate style tilts (such as market cap). Combined with a thoughtful capital allocation and risk management process, the contribution to risk from common factors (e.g., style, sector) may be lower.
This combination of high active share with moderate risk characteristics is unusual. As noted below, most high-active-share long-only managers tend to generate additional “activeness” through concentration (fewer stocks, style tilts, sector tilts, etc.), leading to higher tracking risk and potentially more cyclical patterns of alpha generation.
Figure 2 shows the tracking risk of high-active-share US large-cap core managers. These 123 managers in the eVestment Alliance Large Cap Core Universe had active share of 70% or more as of 31 December 2022. On average, they reported 61 holdings and an ex-post tracking error of 5.1%, with 51 of the 123 managers averaging a higher level of tracking risk.
While concentrated approaches have a role to play for many clients, we think extension strategies represent potentially powerful alternatives for those looking for more alpha without introducing higher tracking risk or for those who wish to fine-tune their passive exposures or large-cap core allocations.
Market risk – expected to have a market-like risk profile; invest in both long and short positions; will experience equity-like volatility; at times, markets experience significant volatility and unpredictability.
Leverage risk – use of leverage may increase the magnitude of investment losses; use of leverage exposes the portfolio to a higher degree of additional risk, including (i) greater losses from investments than would otherwise have been the case had leverage not been used to make the investments, (ii) margin calls that may force premature liquidations of investment positions.
Liquidity risk – may invest in small-capitalization companies; investments with low liquidity can have significant changes in market value, and there is no guarantee that these securities could be sold at fair value.
Derivatives risk – may use futures, swaps, options, forwards and other instruments on equities.
Counterparty risk – counterparty exposure for over-the-counter derivatives transactions.
Transparency risk – holdings and other data is limited, and, thus, less transparent than certain other investments.
Regulatory risk – not subject to the same regulatory requirements as mutual funds or many other pooled investments.
Emerging markets risk – investments in emerging and frontier countries may present risks such as changes in currency exchange rates; less liquid markets and less available information; less government supervision of exchanges, brokers, and issuers; increased social, economic, and political uncertainty; and greater price volatility. These risks are likely significantly greater relative to developed markets.
Equity market risks – equity markets are subject to many factors, including economic conditions, government regulations, market sentiment, local and international political events, and environmental and technological issues.
Manager risk – investment performance depends on the portfolio management team and the team’s investment strategies. If the investment strategies do not perform as expected, if opportunities to implement those strategies do not arise, or if the team does not implement its investment strategies successfully, an investment portfolio may underperform or suffer significant losses.
Short sale risks – a short sale exposes the investor to the risk of an increase in market price of the particular investment sold short, which could result in an inability to cover the short position and a theoretically unlimited loss.
Smaller-capitalization stock risk – the share prices of small and mid-cap companies may exhibit greater volatility than the share prices of larger capitalization companies. In addition, shares of small and mid-cap companies are often less liquid than larger capitalization companies.
Real estate securities risk – risks associated with investing in the securities of companies principally engaged in the real estate industry such as Real Estate Investment Trust (“REIT”) securities include: the cyclical nature of real estate values; risk related to general and local economic conditions; overbuilding and increased competition; demographic trends; and increases in interest rates and other real estate capital market influences.
Risks of derivative instruments – derivatives can be volatile and involve various degrees of risk. The value of derivative instruments may be affected by changes in overall market movements, the business or financial condition of specific companies, index volatility, changes in interest rates, or factors affecting a particular industry or region. Other relevant risks include the possible default of the counterparty to the transaction and the potential liquidity risk with respect to particular derivative instruments. Moreover, because many derivative instruments provide significantly more market exposure than the money paid or deposited when the transaction is entered into, a relatively small adverse market movement can not only result in the loss of the entire investment, but may also expose a portfolio to the possibility of a loss exceeding the original amount invested.
Risks of investment in other pools – investors in a fund that has invested in another fund will be subject to the same risks, in direct proportion to the amount of assets the first fund has invested in the second, as direct investors in that second fund.
Other risks – a security issued by a particular issuer may be impacted by factors that are unique to that issuer and thus may cause that security’s return to differ from that of the market; fund manager has total trading authority over the fund. The use of a single advisor applying generally similar trading programs could mean lack of diversification and, consequently, higher risk; there may be restrictions on transferring interests in the fund; a substantial portion of the trades executed for the fund take place on non-US exchanges; the fund is not required to provide periodic pricing or valuation information to investors; the fund may involve complex tax structures and delays in distributing important tax information.
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1Sources: FactSet; eVestment Alliance. | PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. | Indices are unmanaged and cannot be directly invested into. | 2Source: FactSet. | As of 31 December 2022.
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