Dow Jones Breaks Away From Credit Suisse, S&P with New 130/30 Index

Date: Thursday, March 20, 2008
Author: Christopher Holt, Seekingalpha.com

Dow Jones announced the launch of their 130/30 Index last week, putting the firm in competition with Credit Suisse (CS) and S&P for the attention of 130/30 investors.

Like CS and S&P, Dow Jones simply executes a pre-existing security-selection methodology in a 130/30 format. The security-ranking methodology is called “RBPP” ("required business performance probability”) and it measures companies according to the likelihood that management will meet the business expectations implied by recent stock prices.

In fact, the index is simply a combination of three existing indices. Says the index methodology overview:

The Dow Jones RBP U.S. Large-Cap 130/30 Index is created by combining the core 750 securities with a component that measures an additional 30% long position in the Dow Jones RBP U.S. Large-Cap Leading 30 Index through a 30% inverse exposure to the Dow Jones RBP U.S. Large-Cap Lagging 30 Index.

By simply combining existing indices, Dow Jones is breaking from CS and S&P which construct their indices by overweighting and underweighting, not through “inverse exposure” to a separate index. By contrast, S&P uses “overweights” and “underweights” (see page 9 of their index methodology) and CS also appears to use an integrated optimization, rather than a combination of a base index, a long book and a short book (see page 12 of an academic paper written by the advisors to that index). In essence, it seems the Dow Jones version is simultaneously long and short 30 names.

The appropriateness of this construction has been a point of considerable debate over the past few years. For example, Credit Suisse actually published a research note last fall saying that a coherent 130/30 fund is more “optimal” than the simple combination of its parts. Similarly, Bruce Jacobs and Kenneth Levy, two 1X0/X0 pioneers recently argued in the Financial Analysts Journal ("20 Myths About Enhanced Active 120-20 Strategies"):

Myth 3. A 120–20 equity portfolio can be constructed by combining two portfolios — a long-only 100–0 portfolio and a 20–20 long–short portfolio. This type of construction is possible, but it negates most of the advantages of long–short construction. The real benefits of any long–short portfolio emerge only with an integrated optimization that considers all long and short positions simultaneously, together with any desired benchmark exposure, to produce a single portfolio…

In any event, the particular security-selection model used by Dow Jones is reminiscent of Research Affiliates’ Fundamental Indices in that they attempt to predict future stock prices based on fundamental business metrics such as revenue (what Research Affiliates calls a company’s “economic footprint”). According to the Dow Jones Indexes website:

Dow Jones RBP Indexes measure the likelihood that a company can deliver this performance. The methodology of the indexes employs a robust, quantitative approach to measuring whether a company’s stock is priced appropriately by addressing two fundamental questions: What is the required business performance (RBP®) needed to support the price of the stock? What is the probability that the company’s management can deliver this business performance?

If you’re really into this kind of thing, you might be interested in this white paper by Bjorn Jorgensen of Columbia University which provides the details behind the “Required Business Performance” methodology.

With the growing popularity of 130/30, there will surely be others joining the Short-Extension Day Parade in the near future.