The Theory:

When an investor chooses a basket of stocks to invest in, they are consciously and unconsciously making a bet on the outcome of hundreds, if not thousands of stocks. Their decision may be focused on only 20 stocks, but they are actually making a decision about many more. Why so? The market is made up of literally thousands of stocks. The most active market is described by indexes such as the S&P 500 or the Russell 1000, or broader indexes such as the Russell 3000, or the Wilshire 5000. In choosing to own just 20, the investor implicitly chooses not to own all the others. While not making an explicit decision about the stocks not to own, the investor implicitly has decided to, as compared to the market, go short the stocks he/she has no interest in.

As an example, Exxon, the largest company in the US market, represents over 3% of the total market capitalization of the stock market as described by the Russell 1000. If the investor chooses not to own Exxon, he/she is betting that Exxon will underperform the overall market, or at least the 20 stocks chosen for the portfolio. The market remains long Exxon; the investor is implicitly short Exxon. Often the decision to not own (thereby implicitly shorting) is more important than the decision to own. Think of the impact of the decision to not own the Financials in 2008 would have had on a portfolio. Versus the market, the investor would have shorted over 25% of the worst performing stocks last year.

The concept of 130-30 recognizes this simple fact that investing is a series of decisions to own, and not own, stocks within the overall market. As will be discussed below, the traditional long-only structure is not very efficient once one recognizes the impact that “not owning” and thereby shorting entails.

But first, how does it work?

Mechanically, a 130-30 strategy is structured as follows:

A couple items to notice regarding the structure shown above:

No explicit leverage is utilized in that the additional 30% invested long is financed out of the proceeds of the short sales.

The net long position, and therefore the targeted market volatility, remains equal to the original capital investment of $100. The targeted beta remains at a market neutral 1.0.

Now, the why:

In our discussion above regarding Exxon, it is clear that by not owning Exxon, the investor is shorting Exxon relative to the market by over 3%, its market weight. While this may seem straight forward relative to Exxon, it becomes far more difficult with the rest of the market.

Shown below is the percentage weight of the 1000 stocks that make up the Russell 1000. To the far left is Exxon. After careful examination of the scale on the chart, one will quickly notice that the majority of companies that make up the market are exceeding small. In fact, past the 100th largest company in the Russell 1000, the market weight of each is nearly immaterial. The 100th company makes up just 2/10th of 1% of the market. The 500th company makes up just 3/100th of 1%.

For the portfolio manager, this is problematic. Without the ability to explicitly short, the portfolio manager can elect to “not own,” but the result is immaterial. If the portfolio manager feels just a strongly that the prospects for company A are positive as he/she feels that company B prospects are negative, he/she can overweight company A, but not owning company B will prove irrelevant if company B is not in the largest 100 companies in the market. To examine further, look at the following exhibit:

To look at how 130-30 changes the opportunity set for the manager, consider 3 stocks: Exxon is the largest stock in the Russell 1000, representing 3.19% of the Index; Metlife is the 100th largest stock representing just .21% of the index; and Hasbro is the 500th largest stock representing just .03% of the index. Assumption: portfolio restricted to a maximum 5% position.

The 130-30 structure is referred to as an “active extension strategy.” It occupies a space within the traditional long equity commitment within the overall investment plan. Research over the past 5 years has centered on the Structure’s ability to improve the alpha of a portfolio for the same level of tracking error. As an alpha strategy, the 130-30 structure is designed to more efficiently pursue alpha, thereby complementing the overall structure of the investment strategy.

The MQS 130-30 Strategy

The structure of a 130-30 strategy requires that the portfolio manager make explicit decisions regarding which stocks to bet with, and those to bet against. While shorting as a mechanism has gained a growing acceptance over the past 10 years, most portfolio managers have little or no experience in managing both long and short positions.

The Principals at MQS have over 56 years of combined experience managing long portfolios, and importantly over 15 years of combined experience managing short portfolios.

This experience has taught our team of professionals that the dynamics of successful long investing differ dramatically from the dynamics of successful short investing. One example is the time frame on which good news versus bad news is digested by the market and reflected in the price of a stock. With good news, stock prices tend to react deliberately, causing the stock price to advance over a period of weeks if not months. Bad news, however, tends to be reflected in the price of a stock almost instantaneously. MQS has designed separate models for our long versus short portfolios within the 130-30 strategy. Both are extensively tested to best exploit the differences between long and short investing.

The MQS strategy employs our dynamic weighting scheme. Considered the leading edge in quantitative investing, our dynamic strategy actively measures the drivers of stock prices on a daily basis, and adjusts the model on both the long and the short to best position the portfolio to take advantage.

The MQS record of success. With actual experience in managing both longs and shorts, the MQS models have been tested through the rally going into 2007, and the extreme volatility experienced in 2008. Few other entrants into this compelling segment of the market have, not only the capability, but also the experience to capture its true potential.

Visit the Mariner Mutual Funds website for further information on the 130-30 strategy.