Dow Jones offers another way to determine a rules-based system for shorting and going long at the same time.
Dow Jones has come out with a new index that puts its own twist on the popular 130/30 investing strategy used by hedge funds.
The Dow Jones U.S. RBP Indexes bases its strategy for picking the stocks it should short and take long positions on based on a two-part methodology developed by Transparent Value.
In a 130/30 strategy, a manager takes a short position in stocks that he or she feels will underperform the market and uses the proceeds to take long positions in stocks that he or she feels are likely to outperform. Generally, the strategy involves shorting up to 30% of the portfolio's total value; although the percentages vary, that tends to be the accepted standard.
The trick, of course, is in figuring out which stocks are likely to outperform and which are likely to underperform. Just recently, Standard & Poor's launched the S&P 500 130/30 Strategy Index, which determines its long and short positions based on the ratings assigned to the stocks of the S&P 500 by Standard & Poor's equity analysts.
The DJ U.S. RBP Indexes methodology assigns each company in the Dow Jones Wilshire U.S. Large-Cap Index a Required Business Performance probability (thus the "RBP" in the index series' name) to start.
A company's RBP is based on its discounted cash flow (DCF) and its stock price. Basically, Transparent Value's methodology determines how much in revenues a company would have to generate in order to justify its stock price.
From there, Transparent Value calculates the company's likelihood of achieving its RBP, basing the probability on historical and projected data.
Julian Koski, Transparent Value's president and co-CEO, said the impetus for the methodology grew out of the 1990s dot-com boom, when he and Transparent Value COO and co-CEO Armen Arus were running a private equity fund and needed a way to value firms that were coming to them for capital.
"It was very difficult in the 1990s to make assumptions about a dot-com company. You could not rely on the assumptions. You needed to understand the valuation and work backwards to figure it out - and then figure out if management could actually deliver it. That was the genesis of the idea, and we use DCF to do that," Koski said.
"[The RBP] measures the probability that the management of a company will deliver the performance to support that stock price," he added, noting that DCF models are a very good fit with long-short strategies.
The DJ U.S. RBP index family currently consists of three major indexes: the core Dow Jones RBP U.S. Large-Cap 130/30 Index, plus similarly constructed growth and value versions.
The three headline indexes in the series have the same component lists as the Dow Jones Wilshire U.S. Large-Cap Index and its growth and value subindexes; those three standard indexes represent the core holdings of the DJ RBP U.S. indexes, and the 130/30 strategy is applied over them.
Equal-weighted leading and lagging subindexes are created from the components of the broad, value and growth indexes. The "leading" indexes consist of the 30 stocks in each benchmark index that have the highest RBP probabilities, while the "lagging" indexes contain the 30 stocks in the benchmark with the lowest RBP probabilities.
These leading and lagging indexes put the "30s" in the DJ RBP 130/30 indexes. For example, the Dow Jones RBP U.S. Large-Cap 130/30 Index comprises the standard Dow Jones Wilshire Large-Cap Index as well as a 30% long position in the Dow Jones RBP U.S. Large-Cap Leading 30 Index and a 30% short position in the Dow Jones RBP U.S. Large-Cap Lagging 30 Index. The growth and value versions follow a similar construction.
More Indexes Coming
Koski said that the indexes are designed to underlie products and also pointed out that the data could be applied in quantitative management funds, among other uses. Additional indexes are on their way, including ones covering India and Europe; Koski added that RBP probabilities are a good way to compare companies across country borders.
The DJ RBP indexes are definitely unique as there is currently only one other 130/30 strategy index on the market that has been well-publicized, and that one selects its short and long positions using a completely different standard. It also does not offer growth and value permutations, nor does it offer subindexes for its short and long portfolios.
The indexes also display considerably different performance, with the DJ RBP U.S. Large-Cap 130/30 Index up 14.55% for 2007, versus 6.10% for the S&P 500 130/30 Strategy Index. Meanwhile the DJ RBP U.S. Large-Cap Leading 30 Index was up 22.18%, and the DJ RBP U.S. Large-Cap Lagging 30 Index was down 11.24%.