Unsurprisingly, given our knowledge of history, the highest beta long/short portfolio had the highest return over the last 20 years. Isolating different periods, however, provides a more nuanced perspective. For example, we can see that over the last 12 months the five variations all exhibited nearly identical total returns, while the portfolio that targeted zero beta was able to exhibit positive returns during the market’s Q4 2018 drawdown.
Here we will pause to note a key difference in the first portfolio we constructed and the target beta portfolios.
In the former case, we used the basic math that a long-only active portfolio is equal to a market-capitalization-weighted portfolio plus a dollar-neutral long/short portfolio. By shorting a dollar equivalent amount of market beta, we could isolate the implied long/short.
The remaining long/short exposure may or may not have residual beta within in. For example, USMV has a beta of approximately 0.7, meaning that the long/short portfolio component must have a beta of -0.3. If we hold USMV and an equivalent dollar amount in short S&P 500 exposure, we would generally expect the residual exposure to be negatively correlated to the market (ignoring idiosyncratic returns for a moment).
If, however, we design our portfolio to explicitly be beta neutral, then we might not hold only $0.7 short in S&P 500 exposure for every $1 we hold in USMV. This results in a portfolio that may more explicitly reflect the idiosyncratic returns of the implied long/short active bets taken by USMV.
Source: CSI Data; MSCI; Stevens Futures; Calculations by Newfound Research. Results assume the reinvestment of all distributions. Results are gross of all fees, including, but not limited to, manager fees, transaction costs, and taxes. Past performance is not an indicator of future results.
Unfortunately, up until this point, implementation of this idea requires shorting S&P 500 futures. This is where capital efficiency enters the equation.
The PIMCO StocksPLUS Short Fund (“PSTIX”) provides access to an actively managed portfolio of fixed income securities and overlays that portfolio with a 100% S&P 500 futures short position. On its own, we would have to hold a near dollar-for-dollar amount in our long equity exposures as PSTIX to hedge out beta, making it inefficient.
If, however, we think from a total portfolio balance sheet perspective, things become much more interesting.
Let’s say, for example, that we currently hold a 60% S&P 500 / 40% Bloomberg Barclay’s Aggregate US Bond portfolio and we would like to sell 10% of our equity exposure and 10% of our bond exposure to create a 20% allocation to a momentum/low-volatility barbell long/short portfolio.
To achieve this exposure, here is how we would construct our portfolio:
- Hold 50% of our portfolio in the S&P 500
- Hold 10% of our portfolio in MTUM
- Hold 10% of our portfolio in USMV
- Hold 20% of our portfolio in PSTIX
- Hold 10% of our portfolio in AGG
At first, this appears to be a massive reduction in bonds. However, when we consider that PSTIX provides us exposure to bonds and short S&P 500 exposure simultaneously, the aggregate picture makes more sense. Below we plot the exposure from each position as well as the net resulting exposure. We can see that we do indeed create a 50% S&P 500 / 30% Bond / 20% Equity Long/Short portfolio.
In this commentary, we introduce a simple idea for advisors and individuals to construct long/short strategies when they do not have the ability to explicitly short within their portfolios.
The idea is built from two foundational concepts: (1) active strategies can be thought of as a passive benchmark plus a dollar-neutral long/short strategy, and (2) exploiting capital efficiency. By combining long-only positions with short exposure to the S&P 500 (or other market index), we can isolate the implied active under- and overweight positions as a long/short portfolio.
To achieve our short exposure, we can take advantage of a capital-efficient portfolio such as the PIMCO StocksPLUS Short Fund (“PSTIX”), which provides simultaneous exposure to fixed income and a short S&P 500 position. By thinking holistically about our portfolio, we can replace existing fixed income with PSTIX and create an implied long/short strategy within our portfolio.
This approach is not without its trade-offs. In our example, creating a 20% long/short allocation results in PSTIX accounting for 2/3rds of the portfolio’s fixed income exposure. This means we must not only be incredibly comfortable with the portfolio construction of PSTIX, but we must also be comfortable in the foregone opportunity cost to allocate to other fixed income managers.
This approach may also not be effective for investors who do not currently hold much fixed income. However, for conservative investors wanting to replace existing fixed income exposure with long/short equity, a combination of long-only exposure with PSTIX may be an effective way to take control of the long/short portfolio construction.
As of the date of this document, both Newfound Research and Corey Hoffstein hold positions MTUM and USMV, and Corey Hoffstein holds positions in PSTIX. Newfound Research and Corey Hoffstein do not take a position as to whether these securities should be recommended for any particular investor.