There are many ways to construct and manage portfolios, but in the world of high finance, one active management strategy has caught the eye of many top players, and for good reason. This particular strategy is called "enhanced active equity," but you'll find most people just call it a 130/30 (or sometimes a 120/20). Read on to learn how enhanced active equity can make your portfolio more efficient and profitable.

Enhanced Indexing: A Background to Enhanced Active Equity
Enhanced active equity is similar to a concept you may already be familiar with called enhanced indexing. Enhanced indexing has two goals in mind. The first is to expose your portfolio to an index (or some other given benchmark) to realize market returns. The second goal is to provide exposure to returns derived from active management. This combination of goals can be achieved by exposing the portfolio to an index using a combination of equity and derivative securities. This leaves a portion of the original capital available for managers to use to generate long-only (in other words, buy and hold) active returns.

The combination of equity and derivatives provides full exposure to market returns, while managers can use the remaining capital to generate actively managed returns.

For example, if an investor has a $1,000 portfolio and wants to invest it like an enhanced index fund, the process might go something like this: The investor should ensure that the $1,000 is exposed to market returns. To do this, he or she should buy a combination of the equity that makes up a given index and derivatives that represent the index. The capital used to do this should not equal 100% of the original capital because of the leverage provided by the derivatives. It is important to note that the position still exposes the investor to returns equal to 100% of the original capital. For this example, let's suppose that the investor used $800. The remaining $200 would then be invested in securities that the investor feels will outperform the index.

Enhanced indexing is still subject to a few constraints, though, such as the long-only constraint (which limits investors to long positions) and a restricted amount of residual risk to which the overall portfolio may be exposed. The amount of capital exposed to residual risk is constrained by the amount of capital not used to track the index. These constraints suggest that enhanced indexing may be a suboptimal approach.

Enhanced Active Equity: How it Works
Relaxing the long-only constraint and allowing variable exposure to residual risk leads us to the foundation of the enhanced active equity portfolio.

This approach begins with an index - preferably one that most resembles what managers use as a benchmark. From there, residual risk is obtained by taking both long and short positions in securities that the manager favors or dislikes, respectively. It is important to remember that these positions are neutral in terms of portfolio weight, leaving us with our original index weights, not a portfolio with a beta equal to our index.

The significant part here, however, is the equal offsetting of long and short positions. Some brokers do not require cash collateral when loaning a stock for short sale, but instead allow the client to use a long stock position as collateral. This allows the client to use the proceeds from the short sale to invest in long positions. In return for allowing the client to borrow the stock, the broker may charge him or her a small percentage of the loaned stock's total capital throughout the year (say 0.5%). This would be in addition to any dividends that may occur during the short sale period, just like a traditional broker.

Let's look at another example. Suppose that you have a portfolio with a starting capital of $1,000. From here, your enhanced prime broker loans you $300 worth of stock for a short sale. You use the $300 in proceeds from that short sale to invest into a stock you favor. Your net exposure is now 130% long and 30% short. Your total net exposure to all positions is 160% (100% indexed, 30% long and 30% short.) This same example could be used with 20% to make 120/20s, 40% to make 140/40s. In this particular example you have constructed 130/30s.

Because the long and short active positions were originally equal in value and portfolio weight, adjusting the portfolio to maintain the desired structure is easy through either partially divesting the longs to cover short losses, or vice versa. A correct proportion of value can be transferred to the opposing position to revert the portfolio back to the desired structure.

How Enhanced Active Equity Compares to Similar Strategies
The acute reader may already know what this management technique allows investors to do in relation to a combination of other strategies. A similar strategy is called equity market neutral. It works by basically taking long and short positions that offset each other, so that the portfolio has no net market exposure. This results in returns that are purely derived from residual risk. The other portfolio strategy is just plain indexing. This results in returns that are purely derived from market returns (none from residual risk).

Enhanced active equity, through the use of an enhanced prime broker, allows a manager to gain exposure to both pure market returns and untainted active returns. What once would have required additional capital can now be achieved through one portfolio, leading to enhanced returns. These enhanced returns will be most useful to managers who are responsible for allocating portions of large portfolios, like pension fund managers.

The Bottom Line
In short, the use of enhanced active equity can be of great value to any investor to gain the potential for larger returns on less capital. Developing the enhanced prime brokerage structure allows for long stock positions to be used as collateral for short stock positions. This essentially changes the rules of portfolio management. Relaxing the long-only constraint and eliminating a cap on residual risk allows us to create a more optimal solution to portfolio management.