Transporting Alpha 133
the ability to generate active performance that is independent of the underlying asset class.1
MECHANICS: TRANSPORTING ALPHA FROM A MARKET NEUTRAL EQUITY STRATEGY
Market neutral construction eliminates exposure to the underlying mar-ket index’s risk—and its return. This return, and its associated risk, can be added back by purchasing derivatives, such as futures or swaps, in an amount equal to the invested capital. In the case of a market neutral equity portfolio, for example, the investor can purchase stock index futures to recover exposure to an equity index. The return to the result-ing “equitized” market neutral portfolio will basically reﬂect the market return (the change in the price of the futures contracts) plus the active return (the long-short spread) from the market neutral portfolio. The equitized portfolio will retain the ﬂexibility beneﬁts of market neutral construction, as reﬂected by the long-short spread, while also participat-ing in overall market movements.
Exhibit 8.1 illustrates the deployment of capital for equitized con-struction. This may be compared with Exhibit 3.1 in Chapter 3, which
EXHIBIT 8.1 Equitized Market Neutral Deployment of Capital (millions of dollars)
Source: Bruce I. Jacobs and Kenneth N. Levy, “The Long and Short on Long-Short,” Journal of Investing (Spring 1997).
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illustrates the same for the basic market neutral equity strategy. Here, again, we assume the investor deposits $10 million with the custodial prime broker. Again, $9 million of the initial $10 million is used to pur-chase desired long positions, which are held at the prime broker. This broker also arranges to borrow $9 million in securities to be sold short. Upon their sale, the broker provides the $9 million in proceeds to the securities’ lenders as collateral for the shares borrowed.2
As with the market neutral equity strategy, the investor is subject to Federal Reserve Board Regulation T. Under “Reg T,” which covers com-mon stock, convertible bonds, and equity mutual funds, the combined value of long and short positions cannot exceed twice the value of the equity in an account.3 The investor must also retain a liquidity buffer. With the equitized strategy, however, the investor must also purchase futures— on the S&P 500, say—with a face value of $10 million. As the futures can be purchased on margin, the investor’s outlay will be about 5% of the face value purchased (or about $0.5 million in Treasury bills). This expenditure comes out of the liquidity buffer, leaving it at a level of $0.5 million.
As with the basic market neutral strategy, the shares borrowed to sell short must be fully collateralized. If they increase in value, the inves-tor will have to arrange payment to the securities’ lenders so collateral continues to match the value of the shares shorted. If the borrowed shares fall in value, the money will ﬂow in the opposite direction, with the lenders releasing funds to the investor’s prime broker account. These payments ﬂow to and from the investor’s liquidity buffer daily.
With an equitized strategy, however, the investor also experiences marks to market on the futures position. These will tend to offset the marks to market on the shares borrowed. An increase in the price of the short positions induced by a rise in the overall market, for example, should be accompanied by an increase in the price of the futures con-tracts held long. The marks to market on the futures can thus be used to offset the marks to market on the shorts.
This is illustrated in Exhibit 8.2. Here, we assume that the long and short positions, as well as the futures position, double in value. The inves-tor will now owe the securities’ lenders $9 million on the marks to market on the borrowed shares. But the investor’s account will also receive a $10 million positive mark to market on the futures position. The securities’ lenders can be paid out of this $10 million, with $1 million left over.
Of course, the futures position, having doubled its initial value, is now undermargined by $0.5 million (assuming futures percentage mar-gins remain the same). Purchasing an additional $0.5 million in Treasury bills to meet the futures margin leaves the investor with $0.5 million. This is added to the liquidity buffer, which is now increased in line with the value of the invested positions.
136 MARKET NEUTRAL STRATEGIES
The mechanics of equitized market neutral portfolio construction thus differ from basic market neutral construction in the addition of the futures position and the interaction between the marks to market on the futures and on the short positions. Because of the tendency of the marks to offset, the equitized market neutral strategy does not require as large a liquidity buffer as the basic market neutral equity portfolio. In addi-tion, the equitized portfolio is less likely to have to engage in trading in order to meet marks to market on the borrowed shares.
Of course, the fundamental differences between the equitized and the market neutral portfolios emerge in the differing responses of their return and risk levels to movements in the underlying market. These are discussed below.
Bull and Bear Markets
Exhibit 8.3 illustrates the performance of the equitized strategy in both bull and bear markets. This may be compared with Exhibit 3.2 in Chap-ter 3, which illustrates the same for the basic market neutral equity strategy. Again, we assume that the market either rises by 30% or falls by 15%.
First, it is evident that, unlike the market neutral portfolio, the equi-tized market neutral portfolio does reﬂect market movements. It has a return of 35.4% in the bull market (versus 10.4% for the market neu-tral portfolio) and a return of –9.6% in the bear market (versus 10.4% for the market neutral portfolio). The return, and risk, associated with exposure to the broad equity market have been added back. The portfo-lio can be expected to enjoy gains in bull markets and suffer losses in bear markets.
Perhaps less evident, but extremely important, is that the portfolio retains the value-added provided by market neutral construction. The long-short spread of 5.4%, the same as in the market neutral case, adds to the equitized portfolio’s return in the bull market and reduces the portfolio’s loss in the bear market. This incremental return reﬂects the active return to security selection, which beneﬁts from the added ﬂexi-bility market neutral construction offers in the pursuit of return and control of risk. (Of course, if the long positions in the market neutral portfolio had, contrary to expectations, underperformed the short posi-tions, the long-short spread would be negative, and the active return from the market neutral portfolio would detract from the equitized portfolio’s performance.)
This result underlines one of the major beneﬁts of market neutral port-folio construction and the gist of alpha transport—the transportability of the active return from the basic market neutral portfolio. The active return
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