Managing Active Extension Portfolios

1
Managing Active Extension Portfolios

• Simon Emrich, Morgan Stanley Quantitative and
  Derivative Strategies

Simon Emrich 1 212 761 8254
simon.emrich_at_morganstanley.com
This material is not a solicitation of any offer
to buy or sell any security or other financial
instrument or to participate in any trading
strategy. This material was prepared by the
Quantitative Derivative Strategies ("QDS") group,
a Morgan Stanley sales trading group. Please
refer to important information and qualifications
at the end of this material.
2
120/20, 130/30, 150/50?

• Increasing focus on delivering excess returns
  while controlling systematic risk manager skill
  is key.
• More flexible combinations of active stock
  picking and systematic exposure management
• Diversification vs concentration Disciplined
  risk management
• Short side Balance between incremental risk and
  alpha opportunity

40 Act Active Extension Funds Beta and Tracking
Risk
Historical Beta and Tracking Risk calculated on 1
year of daily returns for period ending Aug 30,
2007 Source Morgan Stanley Quantitative and
Derivative Strategies
3
Active Extension Benchmark More

• All active benchmark-relative portfolios can be
  decomposed as Benchmark long-short fund
• Compared to Long-Only, Active Extension provides
• More Alpha w?. Sum of active weights increase
• Better Alpha structure of long-short portfolio
  al/s changes, IR improves (Clarke, de Silva,
  Thorley 2002)
• Which is more important?

Source Morgan Stanley Quantitative and
Derivative Strategies
4
Expanding the Opportunity Set
Alpha/Beta Combinations

• How much alpha / excess return can be delivered
  with a given strategy?
• Scale of alpha axis depends on market
  conditions, shape of curves does not.
• Some alpha/beta combinations are not reachable
  with long-only portfolios.
• Rise of Active Extension is a function of the
  shrinking scale of alpha axis for long-only
  strategies.

Source Morgan Stanley Quantitative and
Derivative Strategies
5
Cross-Sectional Return and Beta Dispersion

• Cross-sectional return dispersion is linked to
  portfolio activeness
• Scale of alpha axis varies with dispersion

MSCI US
MSCI Europe
MSCI Japan
Source Morgan Stanley Quantitative and
Derivative Strategies
6
How to Deliver Alpha in Active Extension
More or Better?

• Active Extension portfolios share experience with
  long-short absolute return funds
• Asymmetry of long and short behavior
• Concentration vs Diversification
• Marginal risk-adjusted returns volatility-based
  risk measures insufficient
• Active Extension portfolio management has evolved
  in response
• Diversification on short side
• Systematic exposure management
• Flexibility in portfolio structure
• Focus on excess return delivery in some
  circumstances, risk control more important than
  alpha exploitation.

Source Morgan Stanley Quantitative and
Derivative Strategies
7
Cross-Sectional Return Distribution (1996-2007)

• Fat Tails in cross-sectional returns.
• Tradeoff between alpha exploitation and risk
  control.
• Importance of outlier returns on long vs short
  side.

MSCI US
MSCI Europe
MSCI Japan
Source Morgan Stanley Quantitative and
Derivative Strategies
8
Outlier Occurrence over Time (1996-2007)

• Persistence of Outlier occurrence over time.
• But Outliers are unique 40 of universe was
  an outlier at least once, 20 more than once.
• Kurtosis or shock?

MSCI US
MSCI Europe
MSCI Japan
Source Morgan Stanley Quantitative and
Derivative Strategies
9
Outlier Contribution to Alpha Opportunity Set

• Outliers contribute disproportionately to overall
  dispersion.
• Dispersion may over-estimate the available alpha
  a portion is only available if we can identify
  outliers.
• Outlier risk has implications for risk
  management, particularly on short side. Risk is
  not captured by linear factor models
  (volatility-based risk metrics).

Outliers Contribution to Overall Dispersion
Source Morgan Stanley Quantitative and
Derivative Strategies
10
The Structure of Fat Tails

• Outliers are particularly concentrated in
• Non-Value stocks
• Mid- and Smallcap Stocks
• Information Technology, Consumer Discretionary
  and Industrials
• Classic shorting candidates!

Outliers Return Statistics
Source Morgan Stanley Quantitative and
Derivative Strategies
11
Outlier Return Evolution

• Realization of outlier returns very sudden
  hedging / exposure management possibilities?
• Asymmetry between long and short portfolio
  structure implication for portfolio rebalancing.

MSCI US
MSCI Europe
MSCI Japan
Source Morgan Stanley Quantitative and
Derivative Strategies
12
The Evolving Structure of Active Extension
Portfolios

• Increasing focus on delivering excess returns,
  rather than precise gross exposure levels.
• Shorting experience has led to more disciplined
  portfolio management
• Greater diversification on short side to control
  outlier risk
• Time horizons for alpha crystallization
• Funding vs alpha driven shorts
• Manager differentiation will come from optimal
  combination of risk management and alpha
  generation

Source Morgan Stanley Quantitative and
Derivative Strategies
13
(No Transcript)