July 2007

THE RATIONALE FOR "130/30" EQUITY STRATEGIES

So-called 130/30s are popping up all over the place. These strategies are designed to improve alpha and information ratios by employing leverage and allowing for stock shorting. What is a 130/30 strategy? Why Brian James is it attractive? What portfolio Co-Director, construction and risk management Equity Research features are required? How are we employing the strategy at Loomis Sayles?
WHAT IS A 130/30 STRATEGY?

our net exposure is 130% minus 30% or 100%, the same as our Benchmark. Similar strategies could be 110/10, 120/20, 150/50 or even 200/100; however, the industry appears to have adopted the term 130/30 as shorthand for the entire family of strategies.
WHAT MAKES A 130/30 STRATEGY ATTRACTIVE?

The term 130/30 refers to a family of strategies that seeks to enhance the alpha opportunity (amount of performance in excess of a benchmark index) of a long-only portfolio by adding a moderate amount of financial leverage while continuing to use a traditional equity benchmark. For example, Loomis Sayles Research Active Extension Study: in our Research 130/30 Alpha vs. Tracking Error strategy, we continue to 6 benchmark the Portfolio against the S&P 500, 5 but we sell short stocks in the amount of 30% of the Portfolio and use 4 the proceeds from those shorts to buy another 200/100 150/50 140/40 3 130/30 30% of our original 120/20 amount on the long side. 110/10 Long Only 2 We are 130% long and 30% shorthence the term 130/30. Our gross 1 1 2 3 4 5 6 exposure (leverage) is Tracking Error (%) 130% plus 30% or 160% Source: Loomis Sayles (1.6x leverage), while
Alpha (%)

Lets assume for a moment that our benchmark is the S&P 500, that the universe with which we can construct portfolios are the 500 stocks in that index, and that we normally own 50 stocks in our portfolios. With some compromises made for the sake of risk control and portfolio balance, the 50 stocks we own are our highest conviction stocks (i.e., highest alpha potential per unit of contribution to risk) and we are overweight all of them versus their weights in the benchmark. In other words, we are long each

of the stocks versus the benchmark. Similarly, we are underweight, or short versus the benchmark, the 450 stocks we dont own. If we have the ability to discern between the true underperformers (i.e., high conviction shorts) and the merely ordinary stocks we dont own, then with a long-only portfolio we limit our ability to take full advantage of our knowledge because we can only underweight an unattractive stock by its weight in the benchmark. In financial mumbo jumbo, we constrain our information transfer coefficient. If we underweight the stocks we dislike the most just a little bit more (sell the stock short) we could add disproportionately to alpha per additional contribution to risk.
WHY IS 130/30 THE RIGHT MIX? WHY NOT 110/10 OR 200/100?

The chart on the previous page shows a series of efficient frontiers for various strategies based on our Research 130/30 alpha prediction models and numerous Information Ratios at a Given Tracking Error scenarios run through a 180% Northfield portfolio optimizer.* Ideally, one would like to be as 160% far up the alpha scale with as 140% little tracking error (a common measurement of risk versus the 120% benchmark) as possible. Casual observation reveals that at any 100% level of tracking error, the 80% available alpha goes up as we go from 100/0 to 200/100but at 60% a decreasing rate. Some of this 40% tapering off can be attributed to 1 2 3 4 5 6 Tracking Error (%) higher transaction costs, but it Long Only 150/50 130/30 200/100 also mainly reflects the fact that Source: Loomis Sayles the first stocks to be shorted are 1 2 3 4 5 6 the highest conviction shorts. To continue leveraging up lower
Information Ratio
*The scales are used for illustrative purposes only, and we do not claim that our strategies have the alpha and tracking error characteristics indicated by these lines. **The most often cited is Portfolio Constraints and the Fundamental Law of Active Management, Clarke, de Silva, and Sapra, The Journal of Portfolio Management, Fall 2004.

and lower conviction shorts inevitably becomes less efficient. Academic literature** suggests that a 130/30 strategy captures approximately two-thirds of the increase in available information ratio (alpha per unit of tracking error). The chart below shows the theoretical relationship of information ratios at given tracking error levels of our models. A 130/30 strategy has almost as much efficacy as a 150/50 strategy. And going to 200/100 adds precious little more, and only at the cost of higher tracking error. As financial leverage grows, the trickiness of balancing the risk factors between long and shorts grows disproportionately faster. Risk is not a tame beast. It has a mercurial, quasi-psychotic aspect to it, and is therefore hard to calibrate and hard to capture in standard risk and portfolio construction models. For this reason, our view is that 130/30 is the optimum level of leverage. Beyond that level, the risk of portfolio beastliness may outweigh the modicum of increased information ratio.

THE SPECIAL RISKS IN A 130/30 STRATEGY AND HOW WE HANDLE THEM

The essence of alpha creation in a long/short portfolio is to buy undervalued stocks long and short overvalued stocks. These two groups tend to have different risk characteristics. Often, our highest conviction shorts tend to be higher risk/higher beta in nature and more prone to rumor, buzz and shifts in expectations. Currently, they tend to be smaller capitalization than our longs, but six years ago it was the absolute reverse. To some extent, that mismatching of risk (which an optimizer can mitigate only to a degree) is part of the territory, and there have been extended periods of time when speculative stocks outperformed and the shorts simply didnt add alpha. To help balance our long/short risks, we take the following steps:

1 2

We tend to spread our exposure thinner to help minimize the potential damage from any one stock. Our position sizes on the short side are 40%-50% of those on the long side. We employ strict stop/loss disciplines to prevent losses from getting away from us. While our process is multi-layered, our last line of defense is to cover if the shorted stock rises 20% versus the sector from cost or the most recent low. Most importantly, we look for long/short pair trades of similar companies. Our pairs are in the same sectormany have similar betas, most have similar capitalizations and an increasing number may be competitors in the same industry.

These risk controls ultimately can help us achieve a compromise between reaching for alpha and achieving balance. Optimizing that trade-off is a true art put into practice by our portfolio management teams.

This presentation is for informational purposes and it should not be construed as investment advice. We believe the information in this presentation is reliable, but we cannot guarantee its accuracy. Opinions expressed reflect subjective judgments and will evolve as future events unfold. MALR002159
Loomis, Sayles & Company, L.P. | One Financial Center | Boston, Massachusetts 02111 | tel (617) 482-2450 | fax (617) 951-0532 | www.loomissayles.com