| De-mystifying 130/30 funds |
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| The funds industry has wholeheartedly adopted the so called 130/30 funds industry that has been in the US for the last five years. However, despite the ability to ‘short’ a certain portion of stocks, these funds have offered European investors modest returns to date. Are they really as beneficial as has been claimed? |
The opportunity for a fund to short the markets has become a reality thanks to the appearance of 130/30 funds in Europe recently. Thanks to a successful launch on the back of five years of popularity in the US, it seems that 130/30 funds are here to stay.
The strategy on such ‘long-short extension funds’ combines a 100 per cent long portfolio of shares (for example, using a swap or derivative contract) to give full exposure to any general upturn in the market (beta), with a long/short stock picking overlay (alpha). The latter involves allowing the fund manager to short-sell stocks they believe are set to under perform the market by using instruments such as contracts for difference (CFDs) and to use the proceeds from such activity to take active positions in companies that the manager is convinced will outperform. In other words, such funds employ a combination of being 100 per cent net long of the equity market and 30 per cent short of stocks that the manager thinks are overvalued to finance an additional 30 per cent of added exposure to high conviction stocks.
Previously a manger could only reduce the backing for an unfavoured stock, but the 130/30 model allows them to actively short it and increase the money flowing into favoured stocks, thus giving the skillful manager greater freedom to beat the market.
Such funds have proven to be very popular with private and institutional investors in the US for the last five years, where the market is estimated to have reached more than $75 billion today, predominantly on behalf of pension funds. Some industry experts have predicted that these funds will make a seamless transition across the Atlantic to the European market.
130/30’ funds had experienced explosive growth in the US over the last five years, Richard Wilson, head of equities at F&C, believes that in the UK and European marketplace 130/30 funds are also set to whet the appetites of investors, providing the managers have credible track records in stock selection and can access robust risk management systems.
However, even the name ‘130/30’ is somewhat misleading, as explained by Wilson. ‘The ‘130 / 30’ name is therefore something of a misnomer. These funds can be structured with a range of ratios for the short / long positions. Whether that be 120 /20, 140/40 or indeed the most common structure of 130/30,’ he said.
This view has since been endorsed by other asset managers. At the Fund Forum Conference in Monaco, asset managers speaking at a round table discussion said the ‘130/30’ label is now considered a generic term rather than the exact explanation of their strategies as shorted investment can often move to as little as 5 per cent - creating a 105/5 position - or climb to 150/50 positions to accommodate the potential gains to be had in the negative market.
Wilson is also quick to point out that the oft used descriptions of 130/30 funds as half-way houses between long only funds and hedge funds is misleading. ‘While these funds use some of the techniques traditionally associated with hedge funds, namely short-selling stocks, they are demonstrably not hedge funds. They are designed to be net fully invested in the markets, beating an index through judicious stock picking on the overlay. They do not meet the ‘acid test’ of a hedge fund, which is to seek to generate absolute returns that are uncorrelated to general market movements,’ said Wilson.
According to Wilson a further misconception regarding 130/30 funds is that the stocks shorted in the portfolio must fall in value for the strategy to be successful. ‘The 30 per cent short positions must simply in aggregate under perform the 30 per cent invest in active long positions. Providing that happens, the fund manager will generate additional returns for investors. Genuine stock pickers, even on long-only ‘high alpha’ funds, are constantly taking relative short positions against the index by, for example, excluding major index constituents from their portfolios,’ he explained, ‘so long-only stock pickers can move into this space providing they are supported by the necessary infrastructure in terms of risk management, including pre-trade risk analysis, and derivatives dealing,’ he said.
However, early results in the UK 130/30 market have suggested that, despite the greater freedom afforded to fund managers, such funds have not been achieving stellar returns. Of the 38 mostly US-based 130/30 funds tracked by Morningstar that have submitted returns for the year end to August, the average year-to-date is just 3.9 per cent, against a 5.2 per cent total return for the S&P 500.
Another critical factor of the 130/30’s performance in Europe has been the charges being imposed by the formerly long-only houses. The performance -related fee structure for some 130/30 funds can represent a significant increase from those traditionally charged in long-only funds. This is, perhaps, one reason why many money managers have been so quick to offer such funds.
However, given the modest returns being offered by such funds, along with the higher fees related to the funds, the question remains whether traditionally long-only managers are best placed to be shorting equities. This view has been reiterated by a recent report published by Merrill Lynch.
The report, 130/30 Funds: Momentum Continues, blames the underperformance of some US funds on the American strategies’ largely quantitative nature and their inability to cope with volatility. The report encourages investors to look at the longer-term benefits of 130/30 funds. The firm points to consistent outperformance by four model 130/30 portfolios it back-tested over a five-year period.
However, the report also looks at the returns of four synthetic 130/30 strategies since 2002. The portfolios blended dollar-based exposure to the MSCI World index with 30 per cent allocations to equity hedge, equity market neutral, statistical arbitrage and equity non-hedge indices. The hedge components were financed by borrowing at 0.5 per cent above the American one-month interbank rate.
The report found that the model funds had many more positive than negative months compared with the index. Further study indicated that each portfolio had a higher Sharpe ratio than the index, indicating good risk-return characteristics. While this was not ‘absolute proof of the virtues of 130/30’, the report concluded that ‘alpha transport can work’.
Merrill Lynch expects demand for 130/30s to grow more quickly than for mainstream mandates. It points to advantages for fund firms running the products, such as increased margin, greater ability to retain managers and easier linking of pay and performance. However, it also highlights higher systems costs, the difficulty in demonstrating manager competence and the fact that long-only managers are not encouraged to find short ideas. |
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| Article appeared in the November 2007 issue.
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