Martin L. Leibowitz and Anthony Bova
Volume 5, Number 3, Third Quarter 2007
Active equity strategies that are highly benchmark-centric will generally have a minimal impact on fund-level volatility. Since most US institutional portfolios are overwhelmingly dominated by their equity exposure, any incremental tracking error will be submerged by the beta effect. Positive alpha opportunities from tightly beta-targeted strategies can therefore be particularly valuable because they can significantly increase the fund’s total return with only minor increases in the overall volatility or other “beyond-model” forms of risk.
Active extensions strategies such as “130/30” portfolios are intrinsically benchmark-centric and can potentially lead to higher levels of active alpha. The expanded footings open the door to a fresh set of actively chosen underweight positions and provide a wider range of alpha-seeking opportunities for both traditional and quantitative management.
Active extension strategies can be designed to fit within a sponsor’s existing allocation space for active US equity. With proper risk control, an active extension may entail tracking error that is only moderately greater than that of a comparable long-only fund.
A carefully implemented active extension can expand relationships with existing managers. A sponsor may wish to draw upon those active managers that have already been vetted in terms of their alpha-seeking skills, organization infrastructure, and risk-control procedures.
The preconditions for realizing any of these benefits are a credible basis for producing positive alphas in both long and short portfolios, a high level of risk discipline, an ability to minimize and/or offset unproductive correlations, and an organizational ability to pursue active extensions in a benchmark-centric, cost-efficient fashion.