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Title of Presentation Company (Client) Name Date by HC120704004351

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									Who wants to be a millionaire 130/30 portfolio
manager?




John Stainsby, Global Equities Team   +44 (0) 20 7742 3916


2008 CIPFA Conference, Aviemore
                                                         Test Question


    The A1 is the longest numbered road in the UK
    connecting London with Edinburgh. How long is it?


    A.   399 miles                                    Answers:
    B.   409 miles                    1 min. !   1.   A only
    C.   449 miles                               2.   B only
    D.   499 miles                               3.   C only
                                                 4.   D only




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                                                    Test Question


    The A1 is the longest numbered road in the UK
    connecting London with Edinburgh. How long is it?


     Answer: 2
      – B only




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                                                                       Refresher




    What is 130/30?


     A portfolio of stocks, which balances a gross long equity position of
      130% with a gross short position of 30% (the short side provides the
      capital for the additional 30% long position)

     A way to increase return by relaxing the no-shorting constraint and
      increasing efficiency

     A way to exploit negative stock views more effectively

     A strategy that employs more capital towards positive stock views




3
                                                                                    Refresher




    An example of an equity long-short strategy


    Example: equity long-short strategy with 30% short positions
                                                                     130% long/30% short
                                                                    Market exposure = 100%




                                                                             £130
             £100

                                                      £30
                                £30                                           £30


       Buy long £100 with   Sell short £30   Buy long £30 (financed Stock portfolio with net
              cash                           by proceeds from short     value of £100
                                                     sales)



    … making a traditional equity allocation work harder and smarter
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                                                                                           Refresher


    130/30 portfolio construction seeks to increase potential
    alpha

    Better use of information                        Greater diversification of stock bets


                                                                                         150
                            +
                                                               100


        Q1         Q2     Q3        Q4          Q5          Long-only               Long/short
      JPM quintile performance since inception                   Number of stocks

    Greater capital committed to insights            Same net market exposure

                                130%                          100%                       100%
        100%


                                          -30%

             Long-only             Long/short                Long-only              Long/short
             Long and short stock positions                          Net long exposure



    … while increasing investment efficiency
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                                                                          Scenario 1


    What are the key investment criteria that you must have to
    be a successful 130/30 portfolio manager?


    A. A proven ranking process that identifies under- and            Answers:
       overvalued stocks
                                                                 1.   A only
    B. Strong excess return generation in long-only portfolios
                                                                 2.   B and D
       utilising those rankings
                                                                 3.   A,B,C and D
    C. An understanding of the unique risks associated with
       shorting                                                  4.   A,B and C

    D. A quantitative investment process                                30 seconds!




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                                                                                Scenario 1


    What are the key investment criteria that you must have to
    be a successful 130/30 portfolio manager?


     Answer: 4
      –   A, B and C

     Why?
      – A process of ranking both attractive and unattractive stocks is vital in order to
        expand the opportunity set and employ shorting
      – The process does not have to be quantitative, it can also be based on
        fundamental research
      – Short positions behave very differently to longs, which require additional and
        different risk management




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                                                                                    Scenario 2


    What stock would you go long and what stock would you
    short?
    You are a portfolio manager picking stocks for long-only portfolios. You would like to
    invest using a 130/30 strategy. Your in-house US-based retail analyst gives you the
    following information:

    A. Dean Foods: We should have been more aggressive in
       trimming our holdings. We should not add at these levels for      Answers:
       several reasons. DF is going into a rough patch with
       commodity pressures and this will soon mean higher costs.
                                                                         1. Long C, short B
       Would only add to this name at the $20 level... which is 15-16x   2. Long B & C,
       08 EPS estimates.
                                                                            Short A
    B. McDonald’s: We like this company. MCD continues to focus
       on initiatives : improving returns through minimal cost growth,   3. Long A & B,
       focus on store sales, re-franchising and returning cash to           short C
       shareholders. The company is cheap on a PE of 15x, and
       trades at a discount to consumer staples sector (20x).            4. Long B & C
    C. Staples Inc: This company is a category killer at a reasonable
       price, I strongly suggest we should begin to accumulate a
       position in SPLS. I believe that buy-side investors have                     1 min. !
       become very pessimistic on the consumer and have weighed
       down a number of retail stocks. This is my top pick.



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                                                                                                                Scenario 2


    What stock would you go long and what stock would you
    short?

                                            Initial opportunity set                               Expanded opportunity set
                                            January 1, 1986 – March 31, 2007
                                            Quintile performance vs. S&P 500
                                            5%

                                            4%

                                            3%




     Answer: 4
                                            2%

                                            1%

                                            0%
                                                                                     +
                                            -1%

      – Long B & C                          -2%

                                            -3%

                                            -4%


     Why?                                  -5%
                                                     Quintile 1         Quintile 2   Quintile 3    Quintile 4   Quintile 5



      – The answer is not obvious!
      – This example is taken from a long only investment team, which only identifies
        attractive stocks. This team does not research companies they do not find
        attractive
      – Stocks B and C are regarded as attractive stocks
      – Stock A, Dean Foods, is not a strong negative – not strong enough to short –
        whereas McDonalds and Staples Inc are clear positives
      – Having a ranking system is vital. Some fundamental managers don’t have
        any negative insights and hence cannot short. They only follow the stocks
        they find attractive

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                                                                          Scenario 3




     What would NOT characterise your portfolio?

     Which of the following characteristics would NOT apply to your portfolio?

     A. Taking advantage of relative valuation within a sector (i.e. pair trades)

     B. Purely shorting a stock that is overvalued

     C. Always positioned 130% long/30% short

     D. Isolating an outperforming stock (go long) within an underperforming
        sector (short a group of stocks), while maintaining neutrality (no sector
        exposure)




          Answers:
          1: A, B and C               2: A, B and D                      1 min. !

          3: C and D                 4: C only

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                                                                                               Scenario 3




     What would NOT characterise your portfolio?


      Answer: 4
         – C only: Always positioned 130% long / 30% short

      Why?
         – While 130% long / 30% short has been shown to be the most favourable
           positioning, most funds have the flexibility to move from 100% - 140% long /
           40% short depending on the opportunities at the time
     Even a little bit of shorting goes a long way to improving results
     Excess Return
     2.50%
     2.25%
     2.00%                                                 130/30       140/40
                                       120/20
     1.75%                 110/10
     1.50%
     1.25%
     1.00%
          0%                                 25%                                 50%           75%
                                                       Percent Shorting
     Example: Improvement in alpha with shorting at 2% tracking error, 0.6 information ratio
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                                                                                                           Scenario 4




     What would be a good set of positions for your portfolio?

     You are the manager of 130/30 portfolio with the following information:
                            Intrinsic                                             Overall                   Index
        Company               Value           Quality           Catalyst          Quintile   Liquidity      Weight
              A                  3                15                11                 1        34          0.25%

              B                 25                37                10                 2        12          0.20%

             C                  36                56                32                 3        15          0.26%

             D                  69                68                55                 4        24          0.03%

              E                 78                67                85                 5        86          0.01%
     Note: Overall quintiles: 1= best, 5= worst, Liquidity percentiles: 1=best, 100=worst

     Answers:
     1. Overweight stocks D and E, short all the others
     2. Overweight stocks A, B and C, short D and E as a function of investment
        insights, liquidity and cost of shorting
                                                                                                         1 min. !
     3. Overweight stocks A and B, short stock D as a function of investment insights,
        liquidity and cost of shorting
     4. Do nothing and watch the sport on TV!

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                                                                                  Scenario 4




     What would be a good set of positions for your portfolio?


      Answer: 3
       – Overweight stocks A and B, short stock D as a function of investment
         insights, liquidity and cost of shorting

      Why?
       – You should go long your most attractively ranked stocks and short your most
         unattractive stocks
       – Think about how to achieve this within potential restrictions of e.g. liquidity
       – A and B are the most attractively ranked stocks on the ranking, so go long
         these. There is no real information in C
       – D is poorly ranked, so short this stock. There is very limited liquidity available
         for stock E, so don’t short this even if poorly ranked




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                                                                                  Scenario 5




     How does your short position behave?


     You are a portfolio manager selling short 100 shares of XYZ company at £100 per
     share = £10,000 in short positions. The total portfolio value is £50,000 creating an
     exposure on the short side of 20% (=£10,000/£50,000*100).

     Over the following weeks, XYZ company increases to £140 per share. What is your
     short exposure today (not £ loss), assuming that everything else holds constant?



     1. 12%
                                                                  Answer:
     2. 28                                                      1, 2, 3 or 4?

     3. 30%                                                            1 min. !

     4. 5%



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                                                                                         Scenario 5




     How does your short position behave?


      Answer: 3
                  – 100 shares * £140=£14,000 in short positions/£46,000 new value of portfolio
                    = 30%

      Why?
                  – Shorting stocks is different from going long a stock
                  – Short exposure (bet size) increases when the price moves against you
                                         Stock XYZ price increases,
                                                                            -30%
                                             so “bet” increases

                                Short                                  -20%
      Valuation




                                                          20%

                                                                      13%

                                                      Stock ABC price decreases, so
                                                        portfolio weight decreases    Long
                                                            Time
     *Assume 40% price move

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                                                                                                                 Scenario 6




     How do guidelines affect your portfolio?

     You are the manager of a 130/30 portfolio, which has stocks, sector and                               Answer:
     country constraints of relative +/- 2% each. You are looking at your
     positions in the utilities sector
                                                                                                         1, 2, 3 or 4?

     Portfolios 1, 2, 3 and 4 show different possible allocations and their
     absolute weights in the respective stocks and total. Which one is most
     likely to represent the utilities sector in your portfolio, all other things being                      2 min. !
     equal?

                   Intrinsic                          Overall                Index Portfolio Portfolio Portfolio Portfolio 4
      Company        Value      Quality    Catalyst   Quintile    Liquidity Weight % 1 (%)    2 (%)     3 (%)       (%)
          A            51         63          75          4          10          0.5      0.0    -0.3      0.0          0.0
          B            25         12              5       2           11         0.5      0.0    1.0       0.0          0.0
          C            11         15          14          1          15          0.4      2.0    1.0       0.0          0.6
          D            31          2              9       2          18          0.4      2.0    0.9       0.0          0.7
          E            75         23          81          4          19          0.3      0.0    -0.7      0.0          0.0
          F            6           5          13          1          24          0.3      2.5    0.8       2.5          1.1
          G            3          29          50          3          25          0.2      0.0    0.6       0.0          0.0
          H            84         30          88          5          26          0.2      -1.5   -0.7     -1.0          0.0
           J           92         76          69          5          29          0.1      -1.5   -1.0     -1.0          0.0
          K            20         14              7       1          32          0.1      2.5    0.8       2.5          1.2
     Total Utilities sector (absolute weight) %                                  3.0      6.0    3.0       3.0          3.6
     Note: Overall quintiles 1= best, 5= worst, Liquidity percentiles 1=best, 100=worst
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                                                                                 Scenario 6




     How do guidelines affect your portfolio?


      Answer: Portfolio 2

      Why?
       – As per scenario 4, go long the highest ranked stocks and short the poorest
         ranked stocks (Overall quintiles), liquidity permitting
       – In addition, risk management is now employed through portfolio guidelines
         and constraints of +/-2% for sector, stock and country
       – Portfolio B is the most likely. By going long all the highly ranked stocks and
         shorting the poorly ranked stocks, a diversified allocation within the sector is
         created. None of the individual stocks breach the +/-2% and the overall
         relative sector allocation is -0.6%
       – Portfolio 1: The relative sector weight is +3% (breaching the guidelines) and
         stocks F and K are both outside the +/-2% limit
       – Portfolio 3: Similar to portfolio 1, stocks F and K are outside the +/-2% limit.
       – Portfolio 4: There are no shorts employed


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                                                                                 Scenario 7




     Comparing positions in a portfolio…


     You are the head of Global equities in an investment company that manage130/30
     portfolios and long only portfolios. Your portfolio managers use the same
     investment processes. When comparing your positions across the 2 portfolios, what
     could you see?

     1. A stock being overweight in long only portfolio and short in the130/30 portfolio
        from the same team

     2. Some countries have a net short absolute position in the 130/30 fund

     3. A larger number of stocks in the 130/30 portfolio than in the long only portfolio

     4. Some sectors being overweight in one fund, but underweight in the other

     Answers:
     1: B, C and D           3: A and C only
                                                   30 seconds !
     2: C only               4: A, B, C and D
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                                                                                Scenario 7




     Comparing positions in a portfolio…


      Answer: 1
       – B, C and D

      Why?
       – Regardless of strategy, the view on a stock will be the same (Overall quintile)
       – In the case of very small countries, by shorting just a few stocks you could
         have a net short position in that country at the aggregate portfolio level
       – There will be more stocks in the 130/30 portfolio as the opportunity set
         expands by relaxing the no-shorting constraint and employing shorts
       – The sector positions might be different from one fund to the other depending
         on the extra opportunities in terms of shorting




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                                                                              Summary




     130/30… Long-only with a twist!


     What 130/30 is NOT:                        What 130/30 IS:
      A hedge fund                              An extension of the insights of the
                                                  portfolio manager by utilising short
                                                  positions to generate alpha and
      An absolute return strategy
                                                  manage risk

      A volatility reducer                      The use of additional information
                                                  (insight versus information)

      A pure long/short or portable             Equity strategy benchmarked to
       alpha product                              traditional indices

                                                 Higher targeted return with
                                                  attractive information ratio

     The strategy retains many of the same characteristics of a traditional
     long-only strategy…
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