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Credit Suisse, AlphaSimplex Launch 130/30 Index

Date: Tuesday, October 2, 2007
Author: Emma Trincal, Senior Financial Correspondent, Hedgeworld.com

NEW YORK (HedgeWorld.com)—Credit Suisse and AlphaSimplex Group have launched the first 130/30 index. The Credit Suisse 130/30 Index aims to help managers build 130/30 portfolios while also giving them a new benchmark. In addition it should allow Credit Suisse to offer a suite of products derived from the index, from investable indexes to structured notes.

The nascent 130/30 market, estimated by Merrill Lynch to be around $75 billion, is growing quickly as investors and managers actively seek those products, which are a hybrid of long-only and hedge funds and incorporate a limited amount of shorting and leverage. These funds allow managers to short up to 30% of the portfolio and use the proceeds to extend their long positions to 130%, netting a 100% exposure to the market.

The new product fills a gap, since there currently is no index that tracks the performance of 130/30 portfolios. The new Credit Suisse 130/30 Index differs from a traditional benchmark in that it is not a static basket of securities but a dynamic strategy, available in the public domain and totally transparent, said Andrew Lo, Harris & Harris group professor at the MIT Sloan School of Management at the Massachusetts Institute of Technology. Mr. Lo participated in constructing the index.

What the 130/30 market has now are databases. Morningstar runs a database of more than 80 products that fit into the category of 130/30 or 120/20 funds. Most are separate accounts and collective trusts. The average total annual return as of the end of August was 6.1%, well below most equity indexes including the Standard & Poor's 500, wrote Steve Deutsch, director of separate accounts at Morningstar, in an email. Morningstar is not planning a 130/30 index in the immediate future.

The new Credit Suisse index is designed to provide 130/30 fund managers with the tools to create their 130/30 portfolios using 10 alpha factors that are equally weighted and optimized.

"What we did is simple. We gave managers the 10 basic valuation factors, which Credit Suisse's equity division has developed. Using an optimization model, such as the Barra Optimizer or the Northfield Optimizer, managers can construct their own portfolio. It's a do-it-yourself approach. They just apply the 10 factors and equal-weight them," said Mr. Lo, describing what AlphaSimplex Group's risk analytics division did in collaboration with Credit Suisse.

It may be a little more complicated than that, but the principle is similar to what academics and investment banks have tried to implement when launching hedge fund replication indexes: They don't replicate alpha, but instead create alternative beta and make it affordable.

Credit Suisse and AlphaSimplex have plenty of experience when it comes to indexing. AlphaSimplex is a Cambridge, Mass.-based quantitative hedge fund recently acquired by Natixis Global Asset Management LLC, whose founder, Mr. Lo, is an academic pioneer in the field of hedge fund replication research and cloning Previous Reuters Story. Credit Suisse manages the Credit Suisse/Tremont Hedge Fund Index.

Mr. Lo said part of the problem with hedge fund indexes is that few are truly investable, and when they are their capacity is limited. Such is not the case with the new 130/30 index, he said, adding that it fits a formula he defined as a "TIP-ical Index." The "T" stands for "transparent," the "I" for "investable" and the "P" for "passive."

Mr. Lo said he will provide all the details about and the formulas for the new 130/30 index in a paper he plans to publish in a couple of weeks, in collaboration with Credit Suisse. Meanwhile, he will give a presentation of the new index on Tuesday [Oct. 2] at an investor's conference organized by Credit Suisse in New York.

The 10 alpha factors used for the 130/30 index are not proprietary; Credit Suisse makes them known to its clients and has been using them for years. They are basic standard valuation factors for stocks such as price-per-earnings, cash-flow-per-sales and dividend yield. The trick is simplicity. The formula runs those factors through an optimizer and gives each factor an equal weighing.

The index's simplicity makes it easy to reproduce, which allows managers to invest in it, according to Credit Suisse. The indexes will be computed daily, and the calculation methodology will be transparent and replicable. Both Credit Suisse and AlphaSimplex will offer to their respective institutional and other clients synthetic exposures and customized solutions related to the investable indexes.

"Our first goal was to show the marketplace how to think about 130/30 funds in a straightforward and transparent way and see if that strategy is useful or not over a period of time," said Mr. Lo. "Then we wanted to create a useful index, one where you can actually put money in."

For now, the index is just a formula. But the formula is necessary, as 130/30 investing involves both shorting and leverage. That means the portfolio needs to be rebalanced periodically, typically at the end of the month. Mr. Lo said that the new index is not just a basket of securities, but rather, "a recipe on how to change that basket on a monthly basis."

There is no fee to apply this formula and it's a do-it-yourself recipe. That doesn't mean these management tools will be used by small investors, as one needs to be equipped with the optimization tools needed to weigh the 10 alpha factors, but it's a step in that direction.

Credit Suisse doesn't charge any management fee because the investable index has not yet been launched. But by year-end, Credit Suisse will launch an exchange-traded fund-type product pegged to that index, the bank said.

The first investable version of the index will focus on U.S. large-cap stocks, said Mr. Lo. Later on, it will be easy to create a host of other indexes focusing on small-cap or midcap stocks, and other regions of the world.

The idea is to generate interest on the part of long-only managers who want to jump into the 130/30 fray, a little bit like how Vanguard generated interest in 1975 when it launched Vanguard Index Trust, the first index mutual fund, Mr. Lo said. He said he believes in hedge fund replication indexing in general because, "There is no way that hedge funds alone can satisfy the appetite of all the pension funds looking for alternative investment exposure."

A 130/30 index is consistent with Mr. Lo's research on hedge fund cloning, even if 130/30 investing is not strictly speaking an alternative investment style. Mr. Lo said that "there shouldn't be a huge gap between traditional investing and hedge fund investing," adding that "a 130/30 index bridges the gap between those two worlds."

The more alternative investment avenues that are open, the better it will be for pension funds, Mr. Lo said, because in his view the problem is not an excess supply of hedge fund products, but quite the opposite.

"The Yale endowment has had a wonderful performance over the past 15 to 20 years. But keep in mind that they also have a large allocation to alternative investments, between 40% and 50% of their assets," said Mr. Lo.

He said that if all the large pension funds invested on that scale, there would not be enough hedge fund capacity to meet the buy-side's demand; hence, the need to create some room for passive investing, Mr. Lo said. "Hedge funds should not be scared about passive investing, quite the contrary," he said. "The creation of these indexes, if it's done well, is going to be very healthy for both the investors and the hedge funds. It will allow hedge funds to focus on alpha while investors will be able to get the capacity that they need."

Just like all indexes, this new product is intended be used as a benchmark.

Until now, 130/30 managers have benchmarked performance against traditional long-only indexes, which are not designed to capture the long/short nature of 130/30 funds' activities.

"As a 130/30 manager, you can't compare your performance against the S&P 500, since you're using one-to-six leverage" said Pankaj Patel, director of quantitative research at Credit Suisse, in an interview. "We thought there should be a different index that could measure the performance of 130/30 funds. It will raise the bar. But it's also necessary. And if we were not going to do it, someone else was going to do it."

The Credit Suisse 130/30 Index posted a 17.23% average annual return from January 1996 to the end of last week. In comparison, the S&P 500 average annual return was 10.69% during the same period.

The 130/30 Index family will be managed by an Index Committee chaired by Mr. Lo, and the committee vice chairman will be Mr. Patel. Leading industry experts will also be invited to join the Index Committee.