1 Short Selling in an Asset Allocation Framework —the Search for Alpha. Nils S. Tuchschmid Erik Wallerstein Sassan Zaker HEG University of Applied Sciences in Geneva Julius Baer Asset Management

2 Reading Questions Why is short-selling of added value to asset management? Why is there a need to transport Alpha from actively managed funds? How is short selling essential to Alpha transportation? What are the three important factors to consider when employing a alpha-beta portfolio program? Which issues are important to consider when selecting market factors to short-sell? Which are the sources of tracking errors of short-selling market factors?

3 The benefits of a Alpha-Beta program: an example Consider two investment funds  Actively Fund Delivers 11% return and 15% vol. 3% is uncorrelated active returns with 5% vol.  Index Fund Delivers 8% return and 14% vol. Mean-Variance Optimal portfolio

4 The benefits of a Alpha-Beta program: an example Separate the alpha performance of the Active Fund. The Alpha Fund consist of  Long position in the Active Fund  Short position in the Index  Long position in the risk free rate of 3% Mean-Variance Optimal portfolio The increased Sharpe ratio implies large efficiency gains!

5 Employing alpha transportation The three steps of alpha transportation 1. Finding alpha generating active fund managers 2. Estimating Beta exposure Selecting Beta Estimating Beta 3. Shorting beta exposure ETFs and Index funds Futures contracts

6 Employing alpha transportation Tracking errors when shorting market indices Frequency re-weighting ETFs and Mutual Funds with short exposure Futures

7 Porting fund of funds alpha Empirical test to transport alpha from fund of funds Five-factor model: S&P 500, Russell 2000 MSCI EAFE, Barclays Corp. Bond, S&P GS Cmdty. HFR database on 885 fund of funds over the period January 1990 to December 2008

8 Porting fund of funds alpha Comparing 2 cases of mean-variance optimal portfolios  The five market factors + Fund of Funds  The five market factors + Alpha Fund

9 Porting fund of funds alpha Large efficiency gains! Sharpe ratio is on averaged almost doubled. The Alpha Fund leads to significant changes in allocation: Fund of funds as Alternative Asset SP500RSL2000EAFECMDTYBONDAlt. Asset All Fund of Funds (std)(0.5)(2.6)(9.6)(17.0)(33.1)(33.4) Alpha Fund as Alternative Asset SP500RSL2000EAFECMDTYBONDAlt. Asset All Fund of Funds (std)(1.0)(2.3)(4.3)(8.1)(19.6)(21.7)

10 Conclusion Active management is often packaged sub-optimally for end clients Short-selling is the key instrument to isolate alpha performance Leads to large efficiency gains in portfolio construction Three obstacles to implementation: (1) Finding skills, (2) estimating beta exposure, and (3) short-selling them