- Geopolitical Strategist
Sweden, Institutional
ChangeThe views expressed are those of the speaker(s) and are subject to change. Other teams may hold different views and make different investment decisions. For professional/institutional investors only. Your capital may be at risk.
Episode notes
Portfolio managers John Smallcomb and Ed Baldini explain what extension strategies are, how they might benefit investors, and why interest in these strategies has been ticking up.
3:15 – What are extension strategies?
6:15 – Rising interest and room for growth
9:50 – Relative risk
13:35 – Role in asset allocation
15:30 – Extension strategies and the current market
Transcript
Ed: What the extension structure does is to give managers more flexibility in constructing a portfolio to express their best ideas overweights and underweights versus that benchmark. So, more precision, more flexibility, in stock selection and in portfolio construction.
Thomas: Global equity markets continue to be marked by high concentration, and since the reelection of President Donald Trump, they are also contending with higher volatility. Mega tech stocks have cooled a bit amid tariff concerns, but the biggest names just turned in a solid quarter, extending their run. Now, narrow market regimes like this can confound long-only active managers, whose alpha potential is limited by the predominance of a few mega names. Fortunately, there are some better mousetraps that investors can turn to. And one of those is the topic of today's conversation. Extension strategies, also known as 130/30 or 140/40 strategies, go beyond long-only benchmark relative investing in the pursuit of alpha. Joining me today to discuss the long and short of financial markets and how to manage concentration risk are John Smallcomb and Ed Baldini, portfolio managers and longtime veterans of the firm. Ed, John, thank you for both for being here.
Ed: Thomas, good to be here.
John: Nice to be here, Thomas.
Thomas: All right, let me start at the top here and get the lay of the land. So, what are your respective roles and how does your work complement each other?
Ed: Sure. Well, thanks, Thomas. So, Ed Baldini, I've been at Wellington for 20 years. Both of us are members of the investment strategy team here at Wellington. And both of us are focused on running extension strategies. So, these are fundamental 140/40 strategies for the firm. And in those roles, we're responsible for selecting managers who invest in these strategies, allocating the capital, and managing the risk of the portfolios to provide clients with not only the level of return, but the pattern of returns that they expect.
John: And I'm John Smallcomb, another portfolio manager on the extension strategies. I do everything alongside Ed that he mentioned in terms of our responsibilities. We have a great team that supports us in all of those efforts as well. Have been with Wellington since 2008, and I've been working on the strategies now since the end of 2021 with Ed.
Thomas: You're still talking to each other, so I suppose it’s going well.
Ed: Happy couple.
Thomas: Ed, let me, let me again, you know, start with you. But you know, for those that aren't familiar with extension strategies, you know, out in our audience here, can you explain what they are and what are the potential benefits?
Ed: Sure. It's really pretty simple. Extension strategies are long/short equity strategies designed to outperform a benchmark. So, they're different from both traditional long-only in that they use long/short obviously. But they're also different from traditional hedge funds, and the primary difference between extension and a traditional hedge fund is that the net exposure in an extension strategy is typically locked at 100%, and they're run as beta-one strategies. So, the sole focus is to outperform a benchmark, mimic the characteristics of that benchmark in terms of beta and otherwise, but to generate outperformance just like a long-only strategy would.
What the extension structure does is to give managers more flexibility in constructing a portfolio to express their best ideas — overweights and underweights versus that benchmark. So, more precision, more flexibility, in stock selection and in portfolio construction. I'd say the other characteristic is that most extension strategies today are either quantitative strategies or fundamental. And if they're fundamental strategies, the fundamental strategies tend to be multimanager strategies. And the reason behind that is that there's a lot of risk-management work that needs to be done in order to manage the gross exposure I referenced earlier, to get to the intended outcomes for clients. The benefits really relate to this notion of flexibility. So, for every $100 that a client invests, they get a $140 of exposure on the long side, $40 on the short side. So, on the long side, the question is: What do managers do with that additional capital? So, you have that additional $40 for fundamental strategies — typically, what that means is that managers bring in more “best ideas.” So, you're typically trying to outperform a large-cap benchmark. But you can bring in not only your best large-cap ideas but best mid- and small-cap ideas. Second, the shorts really are a subset of underweights because you're managing versus a benchmark. And so, what the shorts allow you to do is have more diversification, more flexibility in how you structure the underweights in your portfolio.
It's interesting, today, markets have become very concentrated, as you alluded to. Today, 86% of the MSCI World benchmark is less than ten basis points in terms of weights of the stock in the benchmark. And so for a long only manager managing versus a benchmark, the most you can do to express an underweight idea is to not own it. So, for most of the stocks in the benchmark, it really doesn't have much of an impact if you just don't own those stocks. So, what an extension strategy does is to allow a manager to underweight any stock in the benchmark by however much they want based on their conviction, and they can also underweight stocks and aren't even in the benchmark at all. So, it's all about providing portfolio managers with more flexibility to structure a portfolio that better reflects their conviction in trying to outperform a benchmark.
Thomas: Makes sense. And, Ed, let me stick with you for a second here. I understand that as a category, these extension approaches have attracted pretty strong inflows recently. So, what's really driving that interest?
Ed: Yeah, it's a good question. They've been toiling away for a long time. There is a history to that. In the mid-2000s there were a lot more extension strategies. Many at that time were quantitatively oriented strategies, and during the global financial crisis in 2008, and really lasting for several years after that, those struggled. Today there's a better balance between quantitative and fundamental strategies, and I think there are really two drivers today that are attracting interest.
One is more clients moving from passive back to active. That really is true — we're not making that up. It’s been a long haul for active versus passive, given how strong US but also global benchmarks have been. But we are seeing clients who, given how concentrated benchmarks have become, they need exposure to the beta, but they want more diversification than the current concentrated benchmarks.
The second source, which has really been more since Covid, there have been clients who have had multiple what are referred to typically as satellite strategies, meaning concentrated growth, concentrated value, concentrated contrarian, various different styles of management where they're trying to create balance across those, all those different managers. It's just been a very tough environment given how concentrated benchmarks have been in high-growth stocks. For those strategies to outperform, extension provides allocators with a way to have a very active portfolio manager with very limited potential risk relative to the benchmark. So effectively accomplishing what clients have been trying to do with satellite-type programs.
Thomas: Got it. So, there's a lot of demand out there still? You think there's growth coming into these strategies?
Ed: Very much so. We're seeing, yeah, really over the last three-to-four years, a lot of clients moving into extension and trying to get more active in their core space, but without taking on an incremental risk in doing that.
Thomas: John, as I just mentioned, you know, these strategies have been around for a while. But I understand there aren't that many of them in the marketplace. So, why is that? And, you know, how have they, evolved, if at all?
John: Yeah. So, it's following on what Ed mentioned. I think that period right after some of the earlier extension approaches launched in the early 2000s, those two events — the summer of 2007, the financial crisis — put some pressure on some of those early extension approaches, and put almost the whole category in, in a penalty box, if you will. I think those that survived that period survived well and are much stronger today. So, there was probably some adaptation —
Thomas: — trial by fire —
John: — exactly — in their investment, processes now. But the other reason, you know, Ed talked about the dynamic of, of many quantitatively driven approaches, and some fundamental, but fewer fundamental extension approaches. And I think the reason for that is it's hard to do. You have you need to have access to good investment managers who can produce good active risk on both the long and short side of the portfolio. So, you can't just take a good long investor and hope that there's good alpha coming from the underweight side of their investment approach. You're putting more exposure to work in the extension structure relative to a long-only portfolio. And so that requires a lot of considerations as well, as Ed talked a little bit about this dynamic, but there's more intense portfolio oversight from, managers who are managing that exposure. You may need central infrastructure to oversee the aggregate of a fundamentally driven approach. The handling of shorts requires extra care, and the transaction costs can be higher, not stable, liquidity can be not stable. So, there's this whole host of, things that we think you need to pull off the extension structure well, in our opinion.
Thomas: So, John, some of those other things are obviously leverage, the use of shorting. How does this play on the risk side of things, when you're talking about an extension portfolio relative to other types of equity portfolios?
John: Yeah, the big difference with the extension portfolio relative to a long-only equity portfolio are twofold. You hit on them, Thomas. One is you have short exposure. And so obviously, the big difference between a long position and a short position is the short has unlimited downside, effectively, to the active position in the portfolio. So that requires handling in the investment process to manage single-name, short outlier risk. You can have shorts behaving commonly for periods of time, too. You can have squeeze events that apply to multiple short positions. So, again, another thing that should be controlled for in the investment process. And to some of the things I just mentioned about varying liquidity and transaction costs, I think all of that is one consideration in the extension approach.
And then again, you have more exposure at risk. Ed talked about the dynamic of, you don't have $100 of capital or exposure at work. And, the extension portfolio may have $180 or $160, depending on the level of gross that's deployed. And so that exposure can vary depending on the makeup of the risk takers or how the alpha is produced in the portfolio. And that requires oversight and risk management in the investment process as well. So those are the two big risks. In our experience, the benefits of that exposure are actually probably greatly outweigh those risks and really allow a manager to do a lot of the things that they had mentioned, and potentially better manage risk in their portfolio, than they can without, without that exposure.
Thomas: Ed, you both mentioned, you know, these, these approaches being referred to as 130/30, 140/40 approaches. What does that level of exposure mean, and why do extension approaches have these varying degrees?
Ed: Yeah, it's a fair question. There are lots of different names referring to pretty much the same thing. The 130/30 or 140/40 is, as John was alluding to, refers to the amount of leverage used in the approach. So, if you invest $100, you get $160 in a 130/30-type strategy — 140/40, more leverage. So, it's referring to the amount of leverage used, in the overall approach. So, I think it's important in terms of the connection that has to risk, and it's a little bit different than a traditional, market-neutral-type of strategy, where the gross leverage has a direct relationship to the level of risk. With an extension strategy because you're managing versus a benchmark, you can have variation in gross leverage that may or may not translate directly to the tracking risk of the approach.
I think in a fundamental strategy, typically what you'll see is managers targeting a level of risk or a level of alpha relative to the portfolio and then adjusting the gross in order to hit that risk target, rather than just locking in on a certain level of gross. And so, the gross will change in fundamental structure typically — and John alluded to this — based on what fundamental managers are doing in terms of their stock picking. Are they understating stocks that are large in the benchmark? You don't need to short Apple to be underweight it. If you don't own Apple and you're managing versus the S&P 500 or the MSCI World, that's a very large bet. But you haven't used any gross at all. But if you're underweighting mid- or smaller-cap stocks, you do need to short them because they're such a small, the small positions in the benchmark. Or they may not be in the in the benchmark at all. So, it's really more about where you're taking the risk, rather than the direct level of risk. So, I think in fundamental strategies, and I think as clients start to evaluate these, it's more important to look at the level of risk in the portfolios than just the level of gross.
Thomas: So all this talk of risk leads to decisions about asset allocation. So, John, what role do you think an extension approach should be playing here along that asset allocation lens?
John: Sure, yeah. I think of it as a core equity position. I think, the way it should sit in an asset allocation program is alongside other active equity and passive equity strategies. So even though it has some of those hedge fund-like skills — the ability to select short ideas and putting together a portfolio that has more ideas in it than perhaps in a long-only portfolio — it usually doesn't fit in an alternatives bucket. It's pretty squarely a beta-one net exposure of 100% equity investment for the investment community. And I think one of the nice features about the active risk of the extension portfolio is that the active risk on the underweight side of the portfolio tends to have low correlation with some of the other mandates that clients may have selected in their equity portfolios.
Ed: Thomas, if I can add one other thought to that, you had asked earlier about what's driving the growth in extension strategies. I think the point John mentioned there is important, which is, clients are figuring out where to put an extension strategy. You go back five, six, seven years ago, there was some concern that it's a long/short strategy, so it doesn't belong in a long-only bucket, but it's also a beta-one net 100% strategy, so it doesn't belong in a hedge fund bucket. Where does it go? I think today there's much more clarity around. It sits in the long-only equity bucket. The goal is to outperform a benchmark. And what we'll see is that the long-only teams are getting more up to speed in terms of evaluating long/short strategies. And, in many cases, they're bringing in their hedge fund counterparts to help evaluate these strategies. So, there's more collaboration in terms of, seeing: Is there skill? Is there risk control, and how can it how can it solve problems?
Thomas: Sounds like the right solution from a Wellington perspective. As the geopolitical strategist, I'm looking at all sorts of disruptions that are happening across the policy and market environments. Of course, the geopolitical environments. So, we're getting a lot more differentiation right at the regional level, at the country level, at the industry level, company level, asset class level. It seems to me that it would be an attractive environment for this type of approach. So, Ed, I'm going to give you the last opportunity to answer the last question here, which is: You know, in your mind what kind of market environments are most suitable for extension portfolios to add value? And more importantly, are we in one of those right now?
Ed: Right. It's a great question. And you know, this year has been an extraordinary year. What I'd say about extension strategies — and in particular fundamental multi-manager extension strategies — is that the design of those portfolios is really to have multiple alpha sources that are really well diversified, so that the risk is really focused on the stock picking of the fundamental managers. And we're really trying in a fundamental strategy to really balance other sources of risk.
So, in an environment where macro is driving more volatility in the markets, where you have more differentiation across countries, more differentiation across sectors, more volatility up and down in the markets, an extension strategy is typically designed so that those really don't have an impact on the relative return of the portfolio. It's really about, within that volatility, are the underlying investors finding opportunities within energy, within technology, within Europe, within Japan, rather than trying to make top-down calls on market direction, countries, currencies, sectors. And, you know, typically the reason why clients find that interesting is that there are many more things to choose from — you have more decision makers involved, running different pieces of the portfolio. So, it's a more diversified, bottom-up way of tackling a volatile environment rather than trying to make two or three big calls and having the portfolio win or lose based on the outcome of that.
Thomas: Gentlemen, thank you so much for spending the time here with us today and discussing this, these opportunities. Incredibly helpful. Once again, John Smallcomb and Ed Baldini, portfolio managers at Wellington. Thanks for joining us on WellSaid.
Ed: Thanks, Thomas.
John: Thanks for having us.
Views expressed are those of the speaker(s) and are subject to change. Other teams may hold different views and make different investment decisions. For professional/institutional investors only. Your capital may be at risk. Podcast produced June 2025.
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