Managing short positions is "not a trivial exercise"
Why did so many 130/30 strategies fail during the global financial crisis?
✈️ 🏖️ I’ll be at Future Proof 9/7-9/9. See you there?
…if investors view 130/30 simply as an extension of long-only investing, they may not bring the full measure of their due diligence resources to bear on manager selection, which could have significant implications given the unique implementation challenges posed by 130/30
DE Shaw, “130/30 Version 2.0” (2012)
Mentioned herein:
AQR (2025): Experience Matters: Addressing Five Common Criticisms of Tax Aware Long-Short (TA LS) Strategies
AQR (2020): Understanding a Tax-Aware Defensive Equity Long-Short Strategy
Meketa (2019): 130/30 long-short equity strategies
DE Shaw (2012): 130/30 Version 2.0
Huang, Wang (2013): Should Investors Invest in Hedge Fund-Like Mutual Funds? Evidence from the 2007 Financial Crisis
Partners Capital (2019): California Taxable Portfolio Management
OG paper… Clarke, de Silva, Sapra (2004): Toward more information-efficient portfolios: Relaxing the long-only constraint
As tax-aware long/short strategies continue growing like crazy (2-sentence, 2-infographic summary for anyone needing a refresher, and approximately $55bn - $65bn AUM as of this writing), it seemed prudent to explore what happened when 130/30 strategies were popular 20 years ago.
In the mid-2000s, 130/30 was hailed as “the new long-only” and one research group predicted1 that “assets in 120/20 and 130/30 active-extension funds will explode from $140 billion in 2007 to nearly $2 trillion by 2010, a 141% CAGR (Compound Annual Growth Rate).”
It's hard to take this prediction seriously.
This, of course, didn't happen. Not even close.
“Explode” turned out to be an extremely unfortunate choice of words.
One lesson from the global financial crisis was that 130/30 is theoretically sound (see DE Shaw, 2012), but several managers lacked experience with short positions, which caused material underperformance or outright failure.
Some managers outperformed, including the JPMorgan U.S. Large Cap Core Plus Fund (JLPSX), a 40 Act fund, which opened in 2005 and is still running today with the same lead portfolio manager2.
The admittedly nuanced point I’m making is that 130/30 stands on solid ground if implemented correctly.
While today’s 130/30 implementations are wowing investors with copious tax losses, that’s putting the cart before the horse.
Before even thinking about tax stuff, the strategy needs to make sense from a pretax risk/reward perspective, especially since today’s variations dial up the leverage considerably (e.g. 150/50, 300/200, etc.).
However, the operational and stock-picking risks remain.
The backstory
This DE Shaw chart3 tells the story of 130/30 assets declining “by nearly 45% from peak to trough,” with more than a third of managers shutting down their products during/following the global financial crisis of 2008-2009.
DE Shaw says it could have been timing (many 130/30 products launched just before the crisis).
But they argue it’s more likely that long-only managers were successfully upselling 130/30, while unsuccessfully managing short exposure.
At the risk of overgeneralizing, managers that entered the market for 130/30 products did so from two different backgrounds. The pedigree of many managers that initially brought 130/30 products to the market (and the vast majority of their assets) was in long-only investing. A much smaller group came to 130/30 from the market-neutral or long/short equity investment space. In 130/30’s early asset-gathering phase, long-only managers had an inside track because 130/30 was effectively positioned as an upgrade to long-only portfolio construction. Those managers thus had a ready pool of existing long-only investors to whom they could cross-sell 130/30 strategies or advocate mandate conversions (and in the process potentially collect higher fees)…
We believe this migration of managers from long-only to 130/30 played a key role in the bursting of the 130/30 bubble…
DE Shaw (2012)
This seems eerily similar to what’s going on today.
Why is managing shorts hard?
DE Shaw 2012 suggests two reasons:
Operational complexity of shorting stocks
Picking shorts is hard (even for skilled long-only stock pickers)
AQR addressed several of the operational issues in Experience Matters:
What about short recalls? Changes in the short borrow cost? Short squeezes?…
These events can indeed wreak havoc in the life of an inexperienced investor. However, with a systematic investment process and a highly specialized and experienced investment team, short borrow cost changes, squeezes, and recalls all fall in the “business-as-usual” bucket. This is what LS managers do for a living.
AQR
I don’t take this operational stuff for granted. Proficiency here is often hard-won. This means inexperienced managers will likely step on some rakes as they learn, which could mean pre-tax performance issues and unexpected capital gains realization.
One way I’ve heard newer managers bootstrap their understanding is by investing their own capital and then perhaps graduating to a small private fund. They develop a track record while ironing out the issues on their own dime.
Things get more complex as products scale (# of accounts, total AUM, more leverage, more benchmarks, more idiosyncracies like corporate actions, etc.), and markets, brokerage practices, and the regulatory environment evolve. So the only real test of proficiency, which I acknowledge creates a high barrier to entry, is scale over a reasonably long stretch of time, where some or all of these things have already happened.
A manager who hasn't done these things with real cash isn't ready for primetime.
Picking stocks is hard
“It seems odd,” DE Shaw wrote in 2012, that stock pickers, who have invested all of their capabilities in forecasting returns of long stock positions, would have equally developed capabilities in selecting short positions. They call this “asymmetric” forecasting ability.
In the case of passive managers, who have invested considerably less in forecasting, it seems especially difficult, to me at least, to leap into long and short active management.
Moreover, borrowing from the method in Clarke, de Silva, Sapra (2004), DE Shaw argues that long-only managers with low “breadth” portfolios (i.e. portfolios where accurate stock forecasting has few independent applications) couldn’t really take advantage of the alpha opportunity afforded by 130/30, anyhow.
This means that the promise of pretax alpha from 130/30 may disappoint investors seeking it if managers lack short forecasting ability or the opportunities to deploy accurate short forecasts.
I did it for the tax
Today’s tax-aware evolutions of the decades-old 130/30 strategies are entering their own hype cycle.
Many advisers (though definitely not all) seem willing to excuse the possibility of underperformance for substantial tax alpha.
Tax can indeed serve as a buffer (see Partners Capital 2019, which argues for more equity-like exposure for just this reason), but in the case of tax-aware long/short strategies, pretax alpha is the foundation on which all subsequent tax alpha is built. Tax is “a very small part of a massive objective function,” a large manager once told me.
Getting all of the pretax stuff right is the gateway to tax efficiency. Tax efficiency smooths underperformance but it (obviously) cannot keep performance afloat forever.
What else could go wrong?
I've written 20ish blog posts about what can go right with tax-aware long/short, and this blog post, hopefully followed by many others, is about what could go wrong.
I think tax-aware long/short is incredibly powerful, but that rings hollow without looking at worst-case, perhaps oddball, calamitous scenarios.
Some of the research analyzing the global financial crisis I mentioned above highlights weak points in 130/30 implementation (though, importantly, not the underlying theory) that can help advisers choose the right managers.
They should, at the very least, choose managers that:
Have operational experience, especially with shorting, under their belts, preferably through a market cycle, and with some scale.
Have experience creating negative stock forecasts and have constructed portfolios that can take advantage of those negative forecasts.
Anything else?
I don’t have a complete list of risks, so I’ll just show my framework for thinking about risk in tax-aware long/short strategies, which will keep evolving:
Operational risk (e.g. short recall, short squeeze)
Active risk (e.g. tracking error)
Capacity risk (e g. How much alpha is out there?)
Counterparty risk (e.g. broker failure, freezing assets, and financing)
Regulatory risk (e.g. limits on short selling)
Legislative and tax authority risk (e.g. changes to federal and state income tax law, case law, and tax authority practice)
Suitability risk (e.g. client has a concrete need for tax-aware long/short)
Planning risk (e.g. adjusting allocation and leverage, deploying tax assets effectively, and contingency and estate planning)
Some of these risks, like operational risk, are industry table stakes.
Counterparty solvency risk is addressable by using multiple counterparties to the extent possible (a key learning from Lehman's failure) and through SIPC insurance. I'll have more to say about the nuances here after a few more conversations.
Other risks are manageable or at least quantifiable, like active risk and perhaps capacity risk.
Regulatory and legislative risk seem more anecdotal and difficult to predict, though we often get some indication of the latter and can assume the former is usually more present during a crisis.
Finally, suitability and planning risk live at the wealth management layer and are a function of adviser proficiency assessing and deploying these strategies. Though there's certainly more that can be done here too.
These are serious and interesting risks for an adviser to underwrite.
It makes the choice of manager behind the scenes extremely important.
The hype surrounding 130/30 in its early years reflected classic bandwagon behavior, with scores of “me-too” products and outlandish growth projections. But in the 2008–2009 period, the bandwagon ground to a halt and then went into reverse.
DE Shaw, 2012
I hope it is not happening again.
Pie
Coffee
Donuts
It is happening again
I am a huge fan of David Lynch’s work, and remember clearly when this tweet landed.
My first David Lynch experience was bewilderment after watching Mulholland Drive, then the premiere of Inland Empire in LA in 2006. Then a random dash through his oeuvre, including the first two seasons of Twin Peaks, Lost Highway, Dune, and of course, Blue Velvet. And also David Foster Wallace’s epic essay. So, when Twin Peaks Season 3 eventually premiered, I was ready.
Sadly, David Lynch died in Jan 2025.
I may revisit some of his work en route to SoCal (for Future Proof) later today.
Honestly, people make predictions like this all the time, so who cares. Except that an MIT professor mentioned this prediction in the opening paragraph of a paper that, as of this writing, has 56 citations, which arguably legitimized it.
Huang and Wang argued in their 2013 analysis of 130/30 funds during the crisis that “this fund’s performance over both the full sample and the pre-crisis periods is very unlikely due to luck.”
Footnote from DE Shaw 2012 on chart construction: “The asset and product data shown in Figure 1 and cited in the text that accompanies that figure are derived from the “Extended Equity” universe of the eVestment Alliance, LLC (“eVestment”) database using quarter-end data. Because managers self-report these asset and product data to eVestment, a number of biases are typically present in any sample of returns or assets over time. However, in reviewing different sources, we believe the direction and magnitude of changes in the market for 130/30 equity products are broadly consistent across estimates. The S&P 500 total return shown in Figure 1 is based on quarter-end data.”
It’s worth mentioning that I refer to several papers in this blog post, which draw on different databases of 130/30 strategies (private funds, mutual funds, etc.). Although the AUM varies considerably, the directional conclusions drawn from the global financial crisis are consistent across the papers.