What is active extension? The long and the short of UK equities
Due to the structure of certain indices, a traditional long-only manager can sometimes find that they are limited as to their freedom to act on their market insight.
Active extension is an equity investment strategy that can give portfolio managers the freedom to turn more of their stock ideas into active portfolio positions, while managing risk more effectively. Active extension strategies can potentially improve alpha generation by allowing managers to take short positions in stocks they think will underperform – creating larger underweight positions in these unattractive stocks than the index would allow.
By taking these short positions, the portfolio manager can then boost exposure to the stocks they like the most. In this way, equity extension strategies allow managers the freedom to invest according to their convictions, both on the long and the short side, while retaining the same 100% exposure to the market as a long-only fund.
So what are short positions?
Portfolio managers establish short positions by borrowing shares in companies whose share price is expected to fall in value, and then immediately selling the shares. The aim is to buy the shares back at a lower price and profit from the difference in value when they are returned to the lender. Short positions give portfolio managers much more scope to add value by profiting from stocks that underperform than in traditional ‘long-only’ equity portfolio, where the ability to underweight stocks is constrained by benchmark weightings.
A typical active extension fund has a gross long exposure of 130% that is offset by a 30% short position, thus the net long exposure is 100%. Chart 1 shows how this strategy is structured.
The net exposure of 100% means that this should be considered a benchmark relative fund – it has 100% exposure to the market and typically a beta of 1. (Beta being market exposure. Active extension and long-only funds are often referred to as Beta One strategies)
This sets active extension apart from long/short hedge funds, which typically have lower and more variable market exposure and focus on absolute returns.
Unlocking the UK Equity market
Benchmarks weighted by the underlying market capitalisation of their constituents tend to be heavily biased to the largest stocks in the universe.
The FTSE All-Share contains many attractive alpha opportunities for skilled stock pickers. However, long only managers’ ability to go underweight stocks, they believe will underperform, is constrained by the benchmark weight of the stock (i.e. a long only manager can only not hold a stock).
Chart 2 shows the distribution of weights for the FTSE All-Share. The index is broad in terms of numbers of stocks, but it is clearly skewed to larger constituents. Of the 633 stocks in the index (as of 20 February 2017 ), the largest 20 stocks make up 52% of the index’s weight, leaving a long tail of 613 stocks that make up less than half the index’s weight.
If we take for instance 1% active weight as a meaningful position then this means that a long only manager will not be able to fully express a negative view on 96% of the index. This is can be an extremely limiting constraint on long only managers’ opportunities to generate alpha from negative views on stocks.
Shorting addresses this issue. Active extension managers can use short positions to “top-up” underweight positions beyond their index weight.
Chart 3 models an example of a £1bn active extension fund using market shorting data from a prime broker. It shows there is a material uplift in the number of stocks that we can express a sizeable negative view when using an active extension strategy.
All portfolios are exposed to desirable and undesirable sources of risk. Desirable sources of risk come from forecasts that should add alpha if those forecasts prove correct. The undesirable risks are a result of aggregated exposures to systematic risk factors, which the manager does not explicitly make a forecast on. The undesirable risks can impact performance even when the manager makes correct forecasts. Ideally a manager would want to hedge out unwanted risks and focus only where they have an edge.
Active extension funds are better than long only funds at hedging these incidental risks. Take size as an example. Most long only portfolios are structurally overweight small and mid-cap stocks. This is due to the fact that they cannot take meaningful underweight position in small and mid-cap stocks (because of their small benchmark weight). Therefore, overweights in attractive mid and small caps are funded by underweights in large cap stocks. Active extension addresses this by funding overweights in mid and small caps through shorting, giving the fund a more balanced size exposure.
The net result is that more of an active extension funds risk budget is spent where the manager has an edge.
- Active extension fund managers can overcome the long only constraint of concentrated equity markets, facilitating easier expression of their views, both positive and negative, while managing risk more effectively.
- The 30% short funds an additional 30% long. This additional 60% gross exposure is all active money.
- Active money in the portfolio is materially increased.
Callum Abbot is fund manager of the JPM UK Equity Plus Fund. Read more about the fund: UK Advisers
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