The Benchmark of a 130/30 Strategy is the Opportunity Set

Well, really the benchmark of ANY strategy is its opportunity set but I thought I would use the 130/30 funds as an example. I have written before about what 130/30 funds are, and how the appropriate benchmark for such a strategy would be the plain vanilla market-cap weighted underlying index.

What Is A 130/30 Strategy?

As an example, Thicken My Wallet recently wrote about HAH which is an ETF that runs a 130/30 strategy on the S&P/TSX 60 index. The manager will buy (or replicate) the S&P/TSX 60 index and then reduce the exposure of the 10 “worst” stocks by 3% each (=30%). If any of those particular stocks have a weighting of less than 3% in the S&P/TSX 60 index then the fund will short sell in order to achieve this net -3% relative exposure. The 30% of the fund’s assets that are freed up are then deployed across the 10 “best” stocks in the S&P/TSX 60 index and their long exposures are increased by 3% each (=30%).

What Is The Best Benchmark For A 130/30 Strategy?

Horizons Alpha Pro, which is the provider of HAH, indicates that the benchmark is the S&P/TSX 60 130/30 Strategy Index, provided by Standard & Poor’s, but I would argue that the S&P/TSX 60 130/30 Strategy Index is only useful in monitoring tracking error of the actual fund. The best benchmark would be the S&P/TSX 60 Index itself.

If you look at any large cap Canadian equity manager, who is holding different weightings of stocks versus the index, they are measured against the plain vanilla index. So why should any other active strategy be treated differently? How else are you going to gauge if the strategy is working or not? The divergence in returns between HAH and the S&P/TSX 60 130/30 Strategy Index will tell you about the fund management’s execution, but the divergence in returns between HAH and the S&P/TSX 60 index will tell you whether the strategy is working or not. They are two different things.

What Do You Mean By Opportunity Set?

The opportunity set just refers to all the investment options available to the fund or manager. A Canadian equity fund, in theory, should only be picking from Canadian stocks and that is the opportunity set. The indices are proxies for the Canadian marketplace and are essentially used interchangeably as the defined opportunity sets (which I might add is sloppy, since there are thousands of stocks listed in Canada but that’s a rant for another day…) :)

Preet Banerjee
Preet Banerjee an independent consultant to the financial services industry and a personal finance commentator. You can learn more about Preet at his personal website and you can click here to follow him on Twitter.
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Showing 4 comments
  • Thicken My Wallet

    Thanks for the mention. Looking forward to more analysis.

  • Aolis

    This strategy seems to be the opposite of Dogs of the Dow.

  • Patrick

    I disagree. Any strategy tracking an index should use that index as a benchmark. The opportunity set for any 130/30 index fund is, in principle, all the other 130/30 index funds (even if there currently are none).

    Anyone can decide whether the strategy is working by comparing the indexes. There's no need to look at a particular fund's performance to tell whether its underlying indexing strategy works.

  • Preet

    According to your logic, all Canadian Large Cap funds (for example) should only consider a peer group analysis when comparing their performance. Why would you not compare it also to the S&P/TSX 60? The answer is, of course you would.

    I think you are confusing “opportunity set” with “peer group”.

    I'm going to have to firmly disagree with your entire comment Patrick! :)

    There certainly IS a need to look at a particular index fund's performance compared to it's index. For example, there are index funds that track the SAME index that can have performance differences of over 5% in a year. Are you going to blindly ignore tracking error?