May 2010
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In the wake of the financial crisis, the search for
risk-efficient sources of return has intensified.
Investors are revisiting asset allocations, refocusing
on risk budgeting and striving to ensure that they are
getting the most from every dollar of invested assets.
We believe that a 130/30 (or extension strategy)
approach, which loosens the long-only constraint on
equity managers, can offer an extremely efficient
means for enhancing alpha and managing risk—and
will continue to gain traction among investors who
need to find ways to make their equity allocations
work harder and smarter.
In our April 2010 webcast, Maximizing Your Equity Allocation—130/30… The story continues, Tom Luddy, portfolio manager for J.P. Morgan’s Large Cap Core Plus (130/30) strategy, moderated a discussion among several of our other experienced extension strategy managers (see sidebar).
The following summary highlights key takeaways from our webcast in which our panelists shared their views and insights on the 130/30 approach including:
Is 130/30 broken? Why has the asset class broadly failed to meet •
investor expectations?
Characteristics for success: Why did some strategies succeed while others faltered? •
The power of 130/30: How do the tools of 130/30 enable skilled managers with a •
proven alpha engine to enhance equity returns while managing risk?
The unique aspects of shorting: What are the risks and how can they be managed? •
A replay of the webcast can be viewed by visiting jpmorgan.com/webcasts. extension strategies:
variations on the 130/30 theMe
strategy: large cap core 130/30 stock selection: Fundamental research-driven Portfolio construction: Manager-driven Benchmark: S&P 500
strategy: large cap value 130/30 stock selection: Fundamental research-driven Portfolio construction: Manager-driven Benchmark: Russell 1000 Value strategy: research 130/30 stock selection: Fundamental research-driven Portfolio construction: Optimizer + qualitative overlay Benchmark: Russell 1000 strategy: u.s. Dynamic Plus stock selection: Quantitative + qualita-tive overlay Portfolio construc-tion: Manager-driven Benchmark: S&P 500 Terance Chen Portfolio Manager Michael rosen Portfolio Manager Tom luddy Portfolio Manager Alan Gutmann Portfolio Manager
Maximizing Your Equity Allocation
2 | Maximizing Your Equity Allocation—130/30… The story continues
be manager driven, optimizer-based or reflect some combi-nation of quantitative and qualitative components.
3. A strong infrastructure in trading, back office and prime brokerage. These are critical areas of expertise whenever shorting is employed.
improving the likelihood of success:
Our panelists manage strategies which represent different variations on the 130/30 theme (see sidebar), incorporating fundamental research-driven as well as quantitative ranking processes and manager-driven as well as optimizer-based portfolio construction. Yet, all would agree with the above “characteristics for success.”
Our 130/30 managers who rely on J.P. Morgan’s fundamental research platform recognize the unique value of our dividend discount rate (DDR) process which provides them with the sec-tor by secsec-tor rankings they need for all the stocks in their investable universe. These rankings are based on the long-term forecasts of future earnings and cash flows developed through the deep knowledge of our U.S.-based sector special-ists, combined with the global perspective of a world-wide research team. As such, they are forward-looking and, com-bined with analysts’ intimate knowledge of the companies they follow, can help ensure that the portfolio manager’s stock selections (both long and short positions) reflect changing market, sector and company dynamics over time.
Few managers have the research infrastructure to cover such a broad range of stocks with this depth of knowledge and experience. While our long-only strategies have relied on this research platform for over 20 years, shorting enables the manager to leverage the full spectrum of rankings, from most to least attractive.
Mike Rosen, manager of our U.S. Dynamic Plus strategy, uses a quantitatively-driven ranking process, but recognized from the strategy’s inception the need to build in the flexibility to respond to changes in underlying market dynamics. He attri-butes his ability to manage through some of the issues of the last three years to “the ability to manage risk more effectively, understand how to short more effectively and build in a quali-tative process to better understand the individual companies and sectors that we’re investing in.”
Is 130/30 Broken?
Why has the asset class broadly failed to meet
investor expectations?
What went wrong with extension strategies in 2007 was not the 130/30 approach itself; many of the underlying alpha engines (the vast majority [70% to 80%] of which are quanti-tatively driven) simply stopped working.
Generalizing somewhat, the alpha engines of many 130/30 strategies are driven by quantitative factor models, built and back-tested on historical data. Model output is used to rank a large universe of stocks—with those at the bottom sold short and those at the top held long. Prior to 2007, these quantita-tive strategies were quite successful. But, in the face of a developing credit crisis, underlying market dynamics changed. As many investors became more concerned with quality and growth (momentum) and less concerned with valuation, these alpha signals failed. Managers, including hedge funds, were forced to sell their long positions (putting downward pressure on stocks expected to increase in value) and buy stocks to cover their short positions (putting upward pressure on stocks expected to decline in value). Shorting, which can magnify returns on the way up, intensified losses on the way down. While these strategies may meet long-term objectives, the ride can be quite volatile.
Characteristics for success
Why did some extension strategies succeed
while others faltered?
130/30 can be an extremely efficient approach for enhancing alpha and managing risk, when the following characteristics for success are in place:
1. A proven ranking process with the breadth of coverage and depth of insight required to evaluate the investable universe of stocks (both under- and over-valued) across market cycles. The process may be quantitative or qualitative. 2. A disciplined portfolio construction process, driven by an
experienced manager who fully understands the unique aspects of shorting and can translate stock rankings and investment insights into efficient portfolios, using shorting to enhance alpha and manage risk. This process too, may
equity returns while managing risk?
As with long-only active managers, our panelists’ performance is measured against a strategy-defined benchmark. When asked what a 130/30 approach enables them to do that could not be done within a long-only strategy, our portfolio manag-ers’ answers and specific examples all reflect a similar objec-tive: Extension strategies, by providing the ability to short, allow the manager to gain greater exposure to high-conviction insights, while isolating that conviction and removing unwant-ed aspects of the exposure. For example:
1. Our Research 130/30 manager, Terance Chen, has a high level of confidence in our semiconductor research team, and saw significant opportunities in the sector. While semicon-ductors have only a 4% weight in the Russell 1000 bench-mark, Terance was still able to express his high conviction insights on specific semiconductor stocks by going long 11% and short 7% in the sector—maintaining a 4% net exposure, while putting 18% of his capital to work.
2. Our Large Cap Value manager, Alan Gutmann, had the follow-ing views on supply/demand conditions for two metals: Copper was in short supply and new, low cost product from Asian markets would have a long lead time; at the same time, there was an excess supply of steel and China could bring additional supply to the market relatively quickly. To gain
tor risk while benefiting from the supply/demand dynamics. 3. As seen in 2007, the extent to which momentum and/or
val-uation factors are driving a market or sector can shift over time. Our U.S. Dynamic 130/30 manager, Michael Rosen, explained how he used a quantitative pair trade to help iso-late a momentum theme in technology (where he believed momentum, but not valuation, was working) while cancel-ling out the valuation impact. As depicted in Exhibit 1: Tech stock A
• has a first quintile (highest, Q1) ranking on momentum and a Q2 ranking on valuation
Tech stock B
• has a fifth quintile (lowest, Q5) ranking on momentum and also has a Q2 ranking on valuation.
By establishing a long position in Tech Stock A and a short posi-tion in Tech stock B, Michael was able to express his positive view on tech momentum, while hedging out the potential impact from valuation. Additionally, since Tech Stock B lies in the third quintile overall (i.e., not in the bottom quintile with stocks ranking Q5 in both momentum and valuation—a typically crowded trade), he hoped to avoid the possible “squeeze” from shorting a stock that hedge funds are likely to be short. This same type of position can be established for valuation, quality or other characteristics where the objective is isolating a convic-tion and managing away some of the unwanted risk exposure.
isolating a momentum theme in the technology sector
exhibit 1a: tyPical Quantitative strategy Pair traDe exhibit 1b: u.s. DynaMic 130/30 Pair traDe—structureD to benefit froM tech MoMentuM While avoiDing a Potential “short sQueeze” Potentially “crowded” trade Percent 0 2 -2 4 -4 6 -6 Long Short Percent 0 2 -2 4 -4 6 -6 Long Stock A Short Stock B Q2 Valuation Q1 Momentum Q2 Valuation Q1 Momentum Q5 Valuation Q5 Momentum Q2 Valuation Q5 Momentum
Maximizing Your Equity Allocation
4 | Maximizing Your Equity Allocation—130/30… The story continues
The unique Aspects of shorting
What are the risks and how can they be managed?
Our portfolio managers emphasized three key risks unique to extension (versus long-only) strategies and discussed potential approaches for managing them:Asymetric risk
Put simply, if a stock is held long and its price declines, posi-tion size decreases—while the risk of loss is limited to the pur-chase price. If a stock is held short and, contrary to expecta-tions, its price rises, the position size increases and the poten-tial for loss is theoretically unlimited.
The risk profile of a short position must be thoroughly under-stood and can be managed by limiting position size, investing in liquid stocks and identifying near-term catalysts that could cause the position to move against you.
Crowded shorts
The risk that a large number of investors want to buy/cover their short positions in a particular stock suddenly and simul-taneously, making it hard to get out of the position without a significant loss.
Using multiple prime brokers and knowing what their inventory contains can provide insight into how “crowded” a short actu-ally is. Avoid stocks with both poor momentum and poor valu-ation as they are likely to be short in many portfolios. Prime broker counterparty risk
The risk that a prime broker suffers severe losses and cannot return cash proceeds held in custody as collateral for short trades.
Here too, it is advisable to have multiple, long-standing prime broker relationships. Having dedicated in-house resources to interface with and perform initial and on-going due diligence on prime brokers is critical and allows the portfolio manager to focus their skills and attention on stock selection and port-folio construction.
additional risk-related concerns also include:
Hard to borrow stocksWhile the cost of shorting rose going into the credit crisis, our managers, at the time of our webcast, viewed costs as basically back to normal, at least within the large cap space. Hard to borrow stocks need not be avoided as long as they are viewed as likely to produce returns justifying the added cost.
Market volatility
While not unique to 130/30 strategies, market volatility requires careful monitoring, given the asymmetric risk of shorting. Our managers have had a multi-faceted response to dealing with the increased volatility of the past few years, including increasing diversification, lowering position size, and being extremely diligent in structuring trades to neutralize unwanted exposures.
Conclusion
We believe that the 130/30 approach can be a powerful tool for generating excess returns and managing risk, when powered by a proven alpha engine and placed in the hands of an experienced manager with a thorough understanding of the unique nature of shorting and a strong infrastructure to support implementation.
With investors now more focused than ever on maximizing returns from their equity allocations, we anticipate that exten-sion strategies will, over time, account for an increasing share of those traditional assets—expanding not only in size but broadening out beyond the large cap space to other categories of equity investments. Regardless of how the story continues from here, we expect the critical factors for success to remain the same.
This commentary is intended solely to report on various investment views held by J.P. Morgan Asset Management. Opinions, estimates, forecasts, and statements of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice. We believe the information pro-vided here is reliable but should not be assumed to be accurate or complete.
These views and strategies described may not be suitable for all investors. References to specific securities, asset classes and financial markets are for illustrative pur-poses only and are not intended to be, and should not be interpreted as, recommendations. The information is not intended to provide and should not be relied on for accounting, legal, or tax advice. Past performance is no guarantee of future results. The manager seeks to achieve the stated objectives. There can be no guarantee the objectives will be met.
There is no guarantee that the use of long and short positions will succeed in limiting a strategy’s exposure to domestic stock market movements, capitalization, sector-swings or other risk factors. Investment in a portfolio involved in long and short selling may have higher portfolio turnover rates. This will likely result in additional tax consequences. Short selling involves certain risks, including additional costs associated with covering short positions and a possibility of unlimited loss on certain short sale positions.
J.P. Morgan Asset Management does not make any express or implied representation or warranty as to the accuracy or completeness of the information contained herein, and expressly disclaims any and all liability that may be based upon or relate to such information, or any errors therein or omissions there from. This material must not be relied upon by you in making a decision as to whether to invest in the opportunities described herein. Prospective investors should conduct their own investigation and analysis (including, without limitation, their consideration and review of the analyses referred to herein) and make an assessment of the opportunity independently and without reliance on this material or J.P. Morgan Asset Management.
J.P. Morgan Asset Management is the marketing name for the asset management businesses of JPMorgan Chase & Co. Those businesses include, but are not limited to, J.P. Morgan Investment Management Inc., Security Capital Research & Management Incorporated and J.P. Morgan Alternative Asset Management Inc.
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