ProShares is launching the first 130/30 ETF strategy (see Pensions & Investments article, Nasdaq article). The 130/30 ETF (CSM) will track the Credit Suisse 130/30 Large-Cap index. The Credit Suisse 130/30 index was developed by Andrew Lo (CIO of AlphaSimplex Group) and Pankaj Patel (director of quantitative research at Credit Suisse). The ETF has an expense ratio of 95 bps, with a strategy that will offer "investors a transparent, low-cost means of achieving 130/30 beta and, potentially, alpha superior to what a comparable long-only large-cap strategy would deliver over the long run." A First Trust 130/30 Large Cap ETN (JFT) based on the 130/30 strategy was released just over a year ago (see previous post, MarketWatch article).

Not familiar with 130/30 strategies? Basically, the strategy uses leverage to short poor performing stocks and then uses the proceeds, along with initial capital, to purchase shares that are expected to do well. If is a form of the general 1X0/X0 long/short strategy, although the 130/30 ratio funds have seem to generate the most interest, producing a 130% long, 30% short strategy. Investors using the strategy will often mimic an index such as the S&P 500 when choosing stocks for the strategy. You can find additional descriptions of the 130/30 strategy here and here. Lo paper here.

Keep in mind that with such strategies the managers must pick stocks to go both long and short. Often there is feeling that you are market neutral, given that you have both long and short positions, but this is not the case. While traditional hedge fund might utilize a long/short strategy that makes them market neutral (beta close to zero), the 130/30 strategy is usually compared to a benchmark, such as the S&P 500, giving 100% exposure to the benchmark. As a result, the strategies are sometimes referred to as beta-one strategies. Furthermore, if the manager gets it wrong in either, or both directions, you may end up losing more than expected. As with most funds, good management is essential, regardless of the strategy.

Given the market beta exposure, these funds are useful if you have a positive market view and you believe that the fund manager can generate alpha from the short portion of the portfolio. If your view is neutral or negative, a hedge fund with an appropriate strategy might be better. If you have a positive market view but are not confident that your manager can generate alpha from short selling, then a long-only fund, or index fund, would be best. Keep in mind that such funds also trade more often, making them less tax efficient compared to traditional long-only index funds.

Note/Update: As a follow-up, I just ran across an excellent article at Greenfaucet that also provides details about the ProShares launch, and the success, or lack of success of the 130/30 funds. Check it out here.

There is an interesting article over at the All About Alpha site regarding the impact of the short selling bans on 130/30 funds. While the article discusses the obvious challenge of maintaining a 30 percent short position when many stocks cannot be shorted, it brings up an interesting point about data and quantitative modeling. As quants go forward with model development, they will need to be careful when back testing their models given the periods of time in the market when short selling was either restricted or tightened for various equities. As one expert was quoted as saying:

"Managers with quant models for generating trades will probably have their heads in their hands. Not only will the quant models have to be redeveloped, but the managers will lose months if not years worth of model evolution, back-testing and intellectual investment. I can predict a few horror scenarios where code and expertise in these models may have been lost.”

There is no doubt that many non-quants or retail investors will say "big deal, isn't it just a bunch of traders taking the hit? Why should I care?" Yet, they should. Besides attempting to make a profit and generate abnormal return, quant funds, like many other strategy based funds, seek to profit from inefficiencies in the market, which ironically helps to keep the market more efficient. When this ability is hampered, as it is when short sale rules are not only changed, but selectively changed, you just add more inefficiency and market volatility (have you seen the VIX lately?).

Sure, naked short selling is wrong, and bans need to be enforced, but interfering with the normal market checks and balances could take months to sort out, even after short selling rules are returned to normal (or at least consistent for more than two weeks at a time). Until then, risk management, arbitrage, and finding someone to take the other side of the trade will be more difficult. All the while, day traders will continue to enjoy the volatility, while retail investors will continue to get nauseous, wondering if things will ever calm down.

As reported from ETFTrends, by way of Seeking Alpha and Yahoo, JP Morgan is launching the first 130/30 Exchange Traded Note (ETN). 130/30 funds were also briefly discussed in this blog a little less than a month ago in a Weekend Link Summary post. As designed, the offered ETN is a modified equal weighted total return index offering 130/30 exposure to large cap stocks.

The offering is certainly an attempt to capture the recent excitement with 130/30 funds, but as mentioned here and elsewhere, many are skeptical that 130/30 funds are nothing more than a traditional long / short fund. In fact, there appears to be nothing magical about the 30% short position, and there is no specific reason to short and only use this level of leverage. A general 1X0/X0 structure could be adapted to develop any long-short strategy that meets your own risk-reward objectives. Hopefully new research, both from academia and industry, will shed some light on whether the 130/30 structure, or something else, provides the best use of the short position and generates the highest risk-adjusted return.