INSIGHTS

“We believe investors have largely overlooked the investment opportunities offered by these strategies in recent years, especially as returns have become more concentrated.”

Introduction

Active extension investment strategies have broadly gone under the radar in recent years. The strategy – which typically operates under a levered structure, whereby a manager holds a net exposure of 100% to the market but can extend their positions by a specified amount on both the long and short sides – was in high demand leading up to the Global Financial Crisis (GFC), particularly in the US. However, it experienced a decline afterwards, largely due to performance struggles in 2008-9.

We believe investors have largely overlooked the investment opportunities offered by these strategies in recent years, especially as returns have become more concentrated. Unlike traditional long-only portfolios, which are limited to buying attractive stocks, active extension portfolios can also short unattractive stocks, providing greater flexibility, portfolio diversification and potential for higher returns. In this paper, we explore the concept of active extension and discuss its underlying mechanisms and potential benefits, particularly in today’s investment environment.

“For stocks with small benchmark weights, managers cannot express an underweight by more than the benchmark weight, significantly limiting their ability to bet against unattractive stocks.”

 

Going the Extra Mile – How Active Extension Works

According to the Fundamental Law of Active Management, the risk-adjusted return (information ratio) of a portfolio is determined by three components: the number of positions taken in the portfolio, the manager’s stock selection skills, and the ability to transform return forecasts into portfolio positions (the ‘transfer coefficient’). Let’s look at each of these components within the context of active extension portfolios and consider how they differ from their long-only counterparts.

Investment breadth

The long-only benchmark constraint can be overly restrictive, limiting a manager’s ability to fully capitalise on their investment insights. In long-only portfolios tethered to the benchmark, managers can only express their negative views of a stock through an underweight position. However, for stocks with small benchmark weights, managers cannot express an underweight by more than the benchmark weight, significantly limiting their ability to bet against unattractive stocks. Due to the cap-weighted nature of the MSCI ACWI Index, these small-weight stocks comprise the majority of the index, with over 99% of MSCI ACWI constituents having a weight of less than 100 basis points.

 

“More than 90% of AuM in active extension strategies today is currently being managed quantitatively.”

 

Stock selection skills

Active extension strategies enable fund managers to generate alpha ideas on both the short and long sides, as these portfolios rely on both the short side and the levered long side as sources of outperformance. More than 90% of AuM in active extension strategies today is currently being managed quantitatively. This is because of quants’ ability to model the entire universe and to utilise a monotonic process to effectively identify long and short investment ideas. By shorting unattractive stocks and reinvesting the proceeds into highconviction long positions, managers can more effectively exploit market inefficiencies, thereby maximising the return potential of the portfolio.

“Active extension enhances the transfer coefficient by providing managers with greater flexibility on both sides of the portfolio.”

 

Implementation

Nevertheless, strong stock selection skills do not necessarily lead to superior portfolio performance. The transfer coefficient, which measures the efficiency with which a manager translates stock return forecasts into actual portfolio positions, is a critical component in determining a portfolio’s risk-adjusted return.

Compared to long-only strategies, active extension enhances the transfer coefficient by providing managers with greater flexibility on both sides of the portfolio. This flexibility enables a more accurate and effective translation of alpha signals into portfolio positions. To demonstrate this, in Figure 2 below, we simulate a set of hypothetical ACWI portfolios with both long-only settings and active extension settings at different levels of leverage. It shows that transfer coefficients, measured as the correlation between alpha predictions and portfolio positions, are generally higher in active extension portfolios than in long-only portfolios. Furthermore, the coefficient progressively increases as the leverage of the active extension portfolios is increased.

 

“Active extension strategies are particularly appealing to investors who would like to maintain full exposure to market beta while seeking higher excess returns compared to traditional long-only strategies.”

 

The Appeal – Why Active Extension?

While the concepts underlying active extension strategies are intuitive, a natural question arises regarding their relevance to real-world investors. Building on the advantages outlined earlier, the active extension framework enhances the potential for excess returns while also effectively managing the associated risks. Consequently, active extension strategies are particularly appealing to investors who would like to maintain full exposure to market beta while seeking higher excess returns compared to traditional long-only strategies. These investors are also willing to accept additional risk in exchange for the potential for higher returns.

To explore the risk and return profiles of active extension strategies, we constructed a set of simulated portfolios using Man Numeric’s standard portfolio construction process and proprietary alpha model. In Figure 3, we apply various levels of leverage, ranging from 110% to 170%, to simulated active extension portfolios. These hypothetical portfolios were all simulated over Man Numeric’s expanded MSCI ACWI investment universe and spanned the period from January 2013 to June this year. As expected, active extension portfolios generated higher excess returns than the long-only portfolio over the simulated period. Excess returns among active extension portfolios also increased as the portfolio’s investment level increased.

 

“Taking on additional active risk usually leads to higher excess returns initially but deteriorates riskadjusted returns beyond a certain threshold.”

 

While active extension strategies offer a robust framework for higher excess returns through active risk-taking, they are not the sole option available to investors. Long-only portfolios, typically subject to stringent controls on beta, sector, and country exposures, can also achieve high tracking errors. However, this generally comes at the cost of relaxed risk controls.

To illustrate this point, we loosened the risk controls of a standard long-only portfolio to construct a long-only portfolio with a tracking error comparable to that of the 130/30 active extension portfolio, which we refer to as ‘the high tracking error long-only portfolio’ for the remainder of this article. As shown in Figure 5, this approach results in a more concentrated long-only portfolio compared to one with standard settings, as evidenced by the reduction in the number of holdings from 328 to 233. Moreover, despite having a similar active risk profile, the high tracking error long-only portfolio fails to match the excess returns achievable through the active extension portfolio.

 

“The simulated active extension portfolio facilitates a more diversified approach to active risktaking by spreading investments across a larger number of holdings.”

 

Beyond the return differential, another critical consideration that distinguishes the active extension strategy is its risk profile. The simulated active extension portfolio facilitates a more diversified approach to active risk-taking by spreading investments across a larger number of holdings. Consequently, it delivers a stronger return compared to the high tracking error long-only portfolio on a risk-adjusted basis. From a drawdown perspective, Figure 6 presents a similar narrative. This chart compares the cumulative drawdown of the 130/30 active extension portfolio with that of the long-only portfolio of similar tracking error. With a more diversified portfolio positioning, the simulated 130/30 portfolio generally experienced smaller drawdowns than the high tracking error long-only portfolio. Both portfolios faced their largest drawdown in 2023. However, the 130/30 active extension portfolio demonstrated greater resilience and a more balanced risk profile, holding up significantly better than the high tracking error long-only portfolio during this period.

It is important to clarify that both the active extension portfolio and the high tracking error long-only portfolio maintain the same net exposure to market beta. The stronger risk-adjusted return and reduced downside risk of the active extension portfolio are not due to the short side offering additional protection during market downturns. Instead, these advantages stem from the relaxation of long-only constraints, which expands stock selection opportunities.

 

“It is no secret that, in recent years, a small group of high-performing stocks has driven the majority of market gains.”

 

Active Extension In Today’s Concentrated Markets

Up to this point, we have focused on the characteristics of active extension portfolios that are agnostic to market environments. However, it is no secret that, in recent years, a small group of high-performing stocks has driven the majority of market gains. This phenomenon, known as return concentration, has led to major indices like MSCI ACWI being significantly influenced by the substantial growth of a few mega-cap companies. This trend has intensified year to date, with only about 25% of the MSCI ACWI constituents outperforming the market capitalisation-weighted index in the first half of the year (Figure 7). These market dynamics present both opportunities and risks for fund managers, but do they also have implications for active extension strategies?

 

“Active extension strategies generally held up better than their long-only counterparts during periods of increasing market concentration.”

 

While return concentration generally poses challenges for managers employing a diversified approach, it has also accentuated the differences between investment strategies and styles.

In examining eVestment manager performance data, we identified a noteworthy historical pattern when comparing long-only and active extension products. Using ACWI portfolios benchmarked to the MSCI ACWI and MSCI ACWI IMI indices as examples, data dating back to 2006 indicates that both long-only and active extension products performed the worst during periods when market concentration became more severe compared to the previous month. Notably, however, active extension strategies generally held up better than their long-only counterparts during periods of increasing market concentration, demonstrating their greater resilience (Figure 8).

 

“While the theoretical return potential of active extension strategies is compelling, their practical implementation presents several significant challenges.”

 

Overcoming Implementation Obstacles

While the theoretical return potential of active extension strategies is compelling, their practical implementation presents several significant challenges.

One main concern is liquidity risk. Shorting necessitates borrowing shares, and if a stock lacks sufficient liquidity, finding shares to borrow without significantly impacting the market price can be challenging. This issue is particularly pronounced among small-cap stocks and in emerging markets, potentially resulting in higher transaction costs and slippage, which can erode the strategy’s benefits.

Short selling also entails higher regulatory and compliance burdens. Regulators often impose stringent rules on short selling, such as uptick rules and mandatory reporting requirements. These regulations can complicate the implementation process and limit the strategy’s flexibility. Additionally, borrowing costs for short positions can be unpredictable and vary significantly based on the stock’s demand and availability. High borrowing costs can erode profits from short sales, making it less attractive to short certain stocks.

“Given these challenges, successfully implementing active extension strategies necessitates a high level of skill and experience from the manager.”

 

From a portfolio risk management perspective, balancing the long and short sides adds another layer of complexity. Managers must continuously monitor the portfolio’s net exposure to ensure it aligns with the desired risk profile. The interplay between long and short positions can create unintended risk concentrations or exposures, particularly in volatile markets. Effective risk management in active extension strategies requires continuous assessment and adjustment of both individual positions and overall portfolio structure to maintain the intended risk-return balance. This demands advanced analytical tools and a proactive approach to anticipate and mitigate potential issues before they impact the portfolio’s performance.

Given these challenges, successfully implementing active extension strategies necessitates a high level of skill and experience from the manager. Managing both long and short positions requires a deep understanding of market dynamics, sophisticated risk management techniques, and the ability to effectively navigate the complexities of short selling and leverage. Managers must be adept at identifying both attractive and unattractive stocks, efficiently executing trades, and dynamically adjusting positions in response to market changes. The expertise and experience of the manager are crucial in overcoming the inherent challenges of active extension strategies and realising their potential benefits.

Conclusion: An Attractive Diversifier

In summary, the active extension strategy offers an attractive alternative to traditional long-only portfolios, particularly in today’s market environment which is characterised by high return concentration. By enabling both long and short positions, active extension portfolios offer increased flexibility, empowering fund managers to better leverage their stock selection abilities and broaden the spectrum of market opportunities.

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