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Modernizing Equity Return Benchmarks

Posted in Strategic Allocation

Does increasingly powerful and more automated trading technology create the need for more sophisticated equity return benchmarks? In the December 2007 version of their paper entitled “130/30: The New Long-Only”, Andrew Lo and Pankaj Patel present a passive but dynamic “plain-vanilla” 130% long/30% short (130/30) benchmark index based on: (1) simple factors (encompassing value, growth, profitability, momentum and technical) to rank stocks; and, (2) standard methods for constructing a portfolio based on these rankings. Applying a standard portfolio optimizer to 10 well-known and commercially available valuation factors for S&P 500 stocks, with monthly rebalancing during 1/96-9/07, they find that:

  • Technological innovations such as automated trading platforms, electronic communications networks, computerized back-office/accounting systems and straight-through processing have changed the meaning of passive investing.
  • The essential criteria for a benchmark index ought to be:
    • Transparent – rules for construction that are systematic, clear and easily implemented.
    • Investable – components that are liquid exchange-traded instruments.
    • Passive – implementation that is purely mechanical, requiring little or no manual intervention and discretion.
  • The average annual return of the 130/30 index is 14.08% with no turnover constraints, and 14.25% (11.76%) with annualized turnover constraints of 100% (15%). The 130/30 index with 15% turnover constraint outperforms the S&P 500 index in nine of 12 years over the sample period.
  • The annual volatility of the 130/30 index is approximately 15%, similar to the 14.68% standard deviation of annual returns for the S&P 500 index. This volatility implies a Sharpe ratio of 0.44 for the 130/30 index (with 15% annualized turnover constraint and a 5% risk-free rate), somewhat higher than the 0.37 Sharpe ratio for the S&P 500 index.
  • The 130/30 exhibits high correlation with traditional equity indexes. (See the chart below.)
  • While typically much lower, there are years when the S&P 500 index turnover approaches that of the 130/30 index. Turnovers for some other traditional S&P indexes exceed that of the 130/30 index, indicating that the 130/30 index is feasible.
  • On average, the 130/30 index with 15% annualized turnover constraint is long 270 names and short 150 names, resembling a typical U.S. large-cap core enhanced-index strategy but with more variable weights.

The following chart, taken from the paper, depicts cumulative returns for the 130/30 index (with 0.25% one-way transaction costs, 0.75% annual short-sales costs, and 15% and 100% annualized turnover constraints) and other popular indexes such as the S&P 500 index, the Russell 2000 index and the Credit Suisse/Tremont Hedge Fund Index. It shows that the 130/30 index behaves much more like a performance-enhanced equity index than the hedge fund index.

In summary, “expect more dynamic strategies [such as 130% long/30% short] to become passive benchmarks as the investor base becomes more sophisticated and demanding.”

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