Discovering Value Through Active Extension Strategies
February 11, 2015
An active extension equity strategy is a cross between a standard long-only mutual fund and a hedge fund. It offers more choices to portfolio managers to allow them to exploit all their investment knowledge; not just the knowledge on stocks that they expect to go up. The objective of an active extension strategy is to outperform a benchmark over an investment cycle with similar net market exposure to a long-only fund. To be clear, it should not be considered an absolute return fund as it will fluctuate with the market.
The most common type of active extension is called a 130/30 fund in which the manager invests 130% of the net assets in a long portfolio and 30% of the net assets in a short portfolio resulting in a fund with net 100% market exposure. In this scenario, as long as the proceeds from the 30% short positions are re-invested in long positions that generate a better return, the fund will go up more or down less than a standard long-only mutual fund. Other examples are 140/40 funds or 150/50 funds.
The main advantages of an active extension fund are:
• It allows portfolio managers to take advantage of all their research rather than discarding half their work because there is nothing they can do after uncovering stocks that they believe to be overvalued
• A portfolio manager can establish short positions in overvalued stocks without decreasing their desired net market exposure
• It makes it easier for managers to participate in emotional sub-sectors such as gold, by pairing positions to limit the exposure to the underlying commodity
This type of fund is managed against an index so it becomes easier to control sector exposure when using short selling strategies. In a typical long-only fund, if a manager decides to be market weight financials, for example, and the portfolio is already market weight, they cannot add a new name without eliminating one. In an active extension strategy, the manager can either eliminate a name or create an offsetting short to maintain sector neutrality. When more investable opportunities are available to portfolio managers, they can better manage risks such as sector exposure through the use of short positions to offset some exposure in sectors where they have a lot of long ideas. Bottom line is that a 130/30 fund is essentially a long-only fund with more tools in the toolbox that a manager can use to reduce risk and to take advantage of all their skills, abilities, and research.
As an example, suppose you wanted to have 3% exposure to each name in your portfolio and maintain a 4% cash weight. In a long-only scenario, you would buy 32 positions at 3% and the portfolio would be complete. In a 130/30 fund, you could take your top 15 ideas and give them a 5% weight (while leaving the remaining 17 positions at a 3% weight) and then offset some of the sector (or subsector) risk/exposure by shorting 15 names at a 2% weight. If your top long ideas outperform your short positions, the portfolio is better off in that it would have gone up more or down less. See the below table for examples (using 6 month returns for illustration purposes):
(5% Long & 2% Short)
|National Bank||11.4%||Laurentian Bank||2.4%||0.34%||0.52%||0.18%|
|Royal Gold||9.5%||Yamana Gold||-45.9%||-0.29%||0.44%||0.73%|
Note that in many cases, you can be “wrong” (e.g. the market can go against you in the short term) on either your long or your short and the portfolio is still better off. For example, shorting Empire Company (Sobeys) would have been a bad short-term call because it went up 21.5% but when paired with an increased weight in Metro, the portfolio made an additional 0.42%. Going long Royal Gold six months ago would have been a bad decision on an absolute basis but by pairing it with a short on Yamana Gold to maintain the same 3% market exposure, the bad trade became an excellent one by adding 0.44% to the overall portfolio return rather than costing it 0.29%. In a long Suncor, short EnCana trade, the portfolio would have still been down due to that trade but not to the same magnitude. Finally, there is the opportunity to be on the right side of both halves such as in a long Inter Pipeline, short AltaGas pair which would have generated an additional 0.41% by using an active extension strategy. The bottom line is that as long as the stock you like does better than the stock you do not like, the portfolio will benefit.
In many countries, active extension funds are considered regular funds that are available to any investor just like a standard mutual fund. However, in Canada, active extension funds are sold as exempt products and are only available to investors under certain exemptions (e.g. accredited investors). Herein lays the opportunity for Canadian accredited investors. The more difficult and time consuming the process to invest is, the fewer number of people will act. The fewer people that invest, the less efficient the market is. The less efficient the market is, the greater the opportunity for investors to profit.
In my opinion, being able to use active extension strategies to buy more of the stocks you like while shorting the stocks that you do not like gives a fund a structural advantage over its long-only peers. Compared to standard mutual funds, active extension funds should go up more in good markets and down less in bad ones. Of course, the investor needs to remember that this is not an absolute return strategy as it still has 100% net equity market exposure. If the market goes down, this strategy will likely also produce a negative return but hopefully it will provide better downside protection through its use of short selling. It should be thought of as a way to diversify some of your equity exposure but, it will still be correlated to market direction and returns.
In conclusion, active extension strategies allow portfolio managers to construct more efficient portfolios without changing risk profiles significantly. Remember that the short positions do not need to go down; they just need to underperform relative to the long positions in order to add value. Managers are able to increase their investable universe through the use of shorting and thus fully benefit from all their research while maintaining the market exposure of a long-only manager. The long term direction of the market has historically been up so having an investment strategy in your portfolio that can protect better on the downside and increase your upside potential seems to be the best you can ask for.
After more than seven years of running a successful offshore 130/30 mandate, Norrep Investments launched the Norrep Canadian Enhanced Equity Fund on January 30, 2015 which is available by Offering Memorandum to accredited and exempt investors in Canada. We are extremely excited about this fund launch and hope that you will contact us for information on this new investment opportunity.
|What is shorting?
Short selling (“shorting”) is the selling of a security not currently owned with the intention of repurchasing (“covering”) it later at a lower price. The trade is profitable if the stock goes down and unprofitable if the stock goes up. Essentially, it is the same as buying (“going long”) a stock and then selling it, only in the opposite order. It allows investors to profit when they find a stock with poor fundamentals, not just when they find “good names”.
PLEASE NOTE: The Norrep Canadian Enhanced Equity Fund is only available for sale to accredited investors, to qualified investors pursuant to the Offering Memorandum Exemption or with a minimum investment of $150,000. Please speak to your dealer for details.
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Keith LesliePortfolio Manager
Keith Leslie is a Portfolio Manager at NCM Investments. Keith leads two of the firm’s alternative investment strategies, with a focus on Canadian equities. He has over 17 years of investment management experience and is an award-winning Portfolio Manager. Prior…
Keith Leslie CFA
- ExpertiseQuantitative Investing
Keith Leslie is a Portfolio Manager at NCM Investments. Keith leads two of the firm’s alternative investment strategies, with a focus on Canadian equities. He has over 17 years of investment management experience and is an award-winning Portfolio Manager. Prior to joining NCM in 2001, Keith worked as a Quantitative Analyst at a western Canadian investment firm.
Keith brings a different perspective to the firm’s investment process, using statistical techniques, valuations tools and modeling. He is the Portfolio Manager of NCM Market Neutral Income Fund, NCM Canadian Enhanced Equity Fund and NCM Core Canadian.
Keith graduated from Western University with a Bachelor of Science in Statistics and Mathematics and is a CFA charterholder.
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