One hundred and thirty /thirty funds are suddenly all the rage. But is the surge in such funds a response to client demand or do fund managers have other motives? Ian Fraser investigates
BARELY a week passes these days without a traditional fund management group jumping onto the 130/30 funds bandwagon. But what lies behind this sudden burst of activity? Is it a response to genuine client demand or are there other motives for the sudden surge in enthusiasm for such vehicles?
130/30 funds deploy a long/short equity strategy using leverage to bolster returns by allocating 130% of the fund’s assets to long positions and shorting 30% of the portfolio to generate cash.
One reason that so many traditional fund management groups are so eager to launch so-called “hedge funds-lite” at the moment is, to put it bluntly, that they can. This type of fund made its debut in Australia in 2004, and began to take off in the United States during 2006.
However in Europe such funds really only became possible in early 2007 as a result of the European Union’s UCITS III regime. Among other things, this regulatory change enabled traditional fund management groups to add whacky new weapons to their investment arsenals — including the use of over-the-counter derivatives, short-selling and leverage.
Pragmatic reasons
It is also clear that traditional fund managers are being driven to launch such funds for understandable pragmatic reasons.
They recognise that their core skill of market-driven (‘beta’) investing is becoming a commodity. To avoid a loss of prestige, falling revenues and to stem an exodus of both funds under management and talent to alternative investment groups including hedge fund managers, many long-only managers have decided to play them at their own game in search of ‘alpha’.
Groups which have already launched 130/30 funds in the UK include UBS, Threadneedle, JP Morgan, Resolution and F&C. Aegon and Bank of New York Mellon are considering it.
However the language routinely used by to describe the launch of 130/30 products is telling. Whenever such a fund is launched, investment commentators and spokespeople generally say that the new fund is being launched “for” an individual, named asset manager.
Mark Tennant says: “That is a real giveaway. Let’s face it – 130/30 funds are a classic example of the fund management industry being a product pusher, rather than launching new products to satisfy end client need.”
The implication is that the new funds are being launched as a vehicle to keep a particular “star” fund manager sweet – and hopefully prevent them from defecting to a hedge fund – rather than because clients are crying out for this sort thing.
However Rick Lacaille, chief investment officer at State Street Global Advisors, disputes the notion that 130/30 funds are self-serving vehicles.
Indeed, he says his firm pioneered the concept of 130/30 funds with its SSgA Edge products in Australia in 2003-4 purely because, after three years of falling equity markets, investors were looking for something capable of delivering outperformance.
“We had clients who wanted a high return relative to the index and we introduced stock index futures and long/short strategy to help provide them with alpha,” says Lacaille. “They actually wanted a product that would outperform the equity market.”
He insists that 130/30 type funds are being sought after by investors “because customers are demanding more alpha on a risk-adjusted basis. Managers are responding to that with different ideas.”
Underwhelming performance
However the distinctly underwhelming performance turned in by the funds launched in the UK this year only reinforces the view that such funds might end up being of less value to investors than to their promoters. For example, of the four UK-managed 130/30 funds launched by JP Morgan in the summer, only the US Select fund has outperformed its index.
And according to Morningstar the 40 130/30-type funds available in the US delivered average returns of just 3.9% in the year to 31 August, compared to a 5.2% rise in the S&P 500 index over the same period. Average returns for funds with a one-year record was 11.3%, compared to 15.1% for the index. Furthermore, this mediocre performance was before the deduction of fees. Perhaps unsurprisingly, these are higher for 130/30 funds than they are for traditional long-only funds.
While fees of 30-50 basis-points are typical for institutional mandates, these rise to 60-100 basis points for 130/30 mandates. And, covetous of hedgies’ earning capacity, some managers are seeking to mimic the “two-and-20” fee structures favoured by hedge funds managers. For example, Threadneedle is demanding a 20% performance fee should its American Extended Alpha fund outperform the S&P 500 index, over and above the 1.5% annual management fee.
In a recent survey of the investment industry by the consultants Create-Research and accountants KPMG, many of the respondents rubbished 130/30 funds. Phrases used to describe them included “another mousetrap”; “an excuse to ratchet up fees”; and “another device to fleece the clients.”
Todd Trubey, an analyst at Morningstar, agrees that 130/30 funds will be no panacea for investors. “Given that the funds have 130% positive exposure to the market and 30% negative exposure to the market, the net result is 100% exposure to the market. So before the manager’s stock picks are factored in, it should behave very much like a standard long-only fund.”
“130/30 funds sound good in theory, but they are extremely dependent on the stock-picking skill of the manager and carry potentially greater risks than long-only funds,” adds Trubey. “Until we see clearer evidence that they can consistently add value over the latter, we don’t think there’s a compelling reason to include them in portfolios.”
Reason for scepticism
Another reason for the scepticism about 130/30 funds is that many of the managers for whom they are being launched have no previous experience of shorting. At the recent Fund Forum in Monaco, Tennant said: “There are probably only 10 or 12 long-only asset managers in the world with the investment management and risk management skill-sets to manage 130/30 funds.”
“Given that the majority of actively managed funds underperform the index, my suspicion that most of the 130/30 funds being launched by active managers will end up leveraging underperformance.”
There’s a fear that the first batch of investors in such funds will effectively find themselves being used a guinea pigs for neophyte investment managers to teach themselves how to short.
However Giles Drury, senior manager in the alternatives group at KPMG, disputes this. “In my view long-only managers who take on such funds will have more trouble getting their heads around complex over-the-counter derivatives than they will with the concept of shorting.”
“My personal view is that a good fund manager ought to be able to make high quality and correct investment decisions and stock selection decisions. They should therefore be able to enhance their performance by using the short-selling capabilities that are available within a 130/30 structure without significantly increasing their risk.”
“If you give better tools to a good manager, they will deliver better results. If you give better tools to a poor or mediocre manager, they are not really going to deliver better results.
Whichever is the case, long-only managers launching such funds will have to get used to doing more research than they have in the past. With long portfolios, they only need to evaluate the most attractive stocks. But with a 130/30 portfolio, their research will need to encompass a wider universe of attractive stocks that are candidates for long positions as well unattractive stocks that are potential short positions.
Global differences
It is worth remembering that there is a major difference between the 130/30 funds launched in the US and Australia and those that have been launched in the UK.
Whereas most of the money invested in such funds in US and Australia has gone into funds that use quantitative screens — essentially passive investment — all the funds that have been launched or else are being mooted in the UK involve active managers.
Could this be the Achilles heel for UK managers? After all, quantitative strategies suit a 130/30 framework much better than active, stock-picking ones. This is because the “quant” method often involves things like prioritising stocks from the most desirable to the least desirable. The fund can simply take the least desirable ones and short them.
One industry insider believes the product type is better suited to “quant” strategies than active ones. “The quant guys find it much easier to make the approach work, as all they need to do is make a minor tweak to their investment process.”
Long-only managers launching 130/30 funds will also have to learn to exist within a much more stringent risk-control framework, than they are used to, as well as getting used to daily contact with their prime brokerage. Traditionally, prime brokers are much more responsive to the needs of hedge fund operators.
If the rush into 130/30 funds becomes as big as some investment banks are predicting, it is going to stimulate massive extra demand for stock lending. Is there a danger this could lead to supply bottlenecks and or pricing pressure?
Deutsche Bank predicts that the new funds could generate a further $600 billion of demand for the securities-lending industry by 2010. This is based the widespread assumption that the money invested in 130/30 investment strategies will rise from its current level of $140bn to $2 trillion over the next three years.
The consensus view is that the availability of large caps is unlikely to be effected. However, a recent report from Deutsche Bank warned of major repercussions for the pricing and availability of mid-tier and hard-to-borrow securities including small caps. For example the rental fees on some small cap stocks with uncertain outlooks could make shorting them uneconomic.
Nick Thomas, head of business development at HSBC Securities Services, says: “Demand for stock borrowing could increase quite dramatically. There’s going to be wall of money as long-only managers move into alternatives. This is clearly going to have an impact on supply and demand especially for “specials” (high demand securities used as general collateral).”
However KPMG’s Drury does not believe that supply issues on the stock lending side is going to cause the 130/30 juggernaut to stop in its tracks. “There is a deep and wide pool of securities that can be shorted. The total hedge fund industry is worth $2 trillion worldwide. But the capital markets — including both equities and bonds — is worth more than $100 trillion.”
Convergence
Remember, it is not just traditional fund managers which are launching 130/30 funds. As part of the trend towards “convergence” in the asset management sector, which was identified by the recent Create/KPMG research, certain existing long/short hedge funds are considering reclassifying themselves as 130/30 funds.
There are big advantages to being considered “traditional” rather than “alternative” investments when seeking mandates from pension funds, whch can hold 130/30 strategies within their mainstream equity portfolios for asset allocation purposes.
According to Pennsylvania-based Turner Investment Partners the best-performing 130/30 funds are going to be those that are managed according to “a sound, proven investment process that incorporates risk-management elements such as stop-loss disciplines, sector neutrality, diversification, and asset-capacity limits.”
David Kocacs, Christopher McHugh and Robert Turner, all partners at Turner Investment Partners, recently said: “As we see it, the best 130/30 portfolios should deliver such an ample margin of alpha over time that the current notion that they are a mere passing fancy may come to seem downright quaint in retrospect.”
SSgA’s Lacaille is confident the fund type has staying power. “The beautiful thing about 130/30 is it enables you to get much closer to neutral in areas where you don’t have a view. For example a long-only fund might end up going overweight in house-builders, just because there’s one housebuilder among the nine listed players that it likes, even though he knows the other eight are going nowhere. This sort of anomaly can be avoided in a 130/30 strategy.
“If a company has a five basis points weight in the index, even if a long-only manager knows with certainty that company is about to go bust, all he or she can do is not hold it. On the other hand, if the manager is allowed to take a short position in that security, his potential gains are very substantial – and that’s what a 130/30 strategy allows you to do. It enables you to control risk much more effectively.”
And KPMG’s Drury is so bullish of the sector he predicts the money in 130/30 funds will ultimately eclipse the $2 trillion assets currently in hedge funds.
However at this stage in the game, the jury is out. The mousetrap is built but it is anybody’s guess as to whether this one is going to be any better or worse than what came before. To a large extent, the conclusion lies in the hands of individual managers “for” whom 130/30 funds have been launched.
This article was published in the Winter 2007 issue of EFM – European Fund Manager