130/30 Panel (August 2007) - Positioning for returns

Andrew Kelly
Fund manager
Cartesian Capital Partners
Kelly began his career in Standard Life in 1987 shortly after completing a maths degree at Durham University. While at Standard Life, Kelly qualified as a fellow of the Faculty of Actuaries, and completed an MSc in investment analysis (with distinction) through Stirling University with a dissertation on Z-Scores. He moved to SVM in early 1996. While there, Kelly was a contributing analyst to hedge funds, and was portfolio manager of the SVM Saltire Long Short Equity Fund, in addition to various long-only mandates, regular client reporting and pitching for new business.

Nick Adams
Director of Institutional Business, Henderson Global Investors
Adams joined Henderson’s Institutional Business in 2004 and is responsible for a number of client and consultant relationships. He is also institutional product specialist for Henderson’s multi-strategy equity team who manage enhanced index and 130/30 portfolios, and market neutral hedge funds.

Peter Ball
Managing director, UK institutional business
JPMorgan
Ball’s team is responsible for JP Morgan’s Institutional clients as well as our relationships with investment consultants in the UK. An employee since 1998, Ball was previously head of Fleming Pooled Pensions, and Fleming’s UK Institutional Marketing team.

Huw Price
Derivative wrapping specialist
Commerzbank Corporates & Markets
Price has over 19 year’s experience in financial services. After leaving university Price joined Target Life, moving within the TSB group, firstly to TSB Life and Pensions and then Hill Samuel Asset Management.
Price started his career in compliance specialising in regulated collective investments schemes joining AXA as a retail compliance officer and then moving to manage UK product development. After two years in a consultancy, Price joined Commerzbank Corporate and Markets in 2006 to develop the UK structured products business and provide fund wrappers for the equity derivatives team.


There is currently a lot of “buzz” about 130/30 funds. What are the attractions of this type of investment?

Kelly: Traditional long-only products naturally allow fund managers to reflect a positive view on companies they like through an overweight position against their chosen benchmark for example FTSE All-Share.
In contrast, however, they are rarely able to add significant value on any negative views on stocks. If they believe a share price will fall, or underperform, they can do little other than to avoid the stock.
A 130/30 product allows a manager not just to have a zero weight but actually to be short of the stock (i.e. have a negative weight). Furthermore, the gearing aspect of a 130/30 structure allows managers to carry an even greater emphasis on their favourite long ideas.
Indeed, the balance between the extended long portfolio and the smaller short portfolio, if managed carefully, can bring extra return potential without adding proportionate risk to the fund. In summary, managers with strong conviction both on the positive and the negative, will have greater opportunity to reflect such strong views within a 130/30 product.

Adams: The potential to achieve strong risk-adjusted returns is the key attraction of these strategies. Many 130/30 funds use an investment process that is a natural extension of an existing enhanced index process.
Enhanced index has been shown by many managers to deliver high information ratios, but at relatively low levels of outperformance. A key constraint for enhanced managers is not being able to short stocks.
Once this constraint is lifted, as with 130/30 funds, the same efficient conversion of risk into return seen in enhanced index can be applied at higher levels of outperformance, so long as the manager has the necessary skills, experience and supporting infrastructure.

Ball: Ultimately, more and more pension plans and their advisers are seeking higher alpha investments – 130/30 is a natural way of extending existing products to achieve the higher returns they crave.
130/30 works by giving fund managers the freedom to attain greater returns from their investment insights and processes. This is done by enhancing traditional long-only investing by taking an extra short exposure in unattractive stocks, offset by further long positions in the most attractive companies.
130/30 managers are therefore able to translate more of their insights into active positions, giving them the opportunity to benefit materially from the stocks they believe will fall in value as well as those that they believe will rise.
Imagine a manager with a particular set of information about a sector (worth 4pc of the benchmark). In the table below, the long-only manager invests the entire 4pc in the stock which has his highest expected return.
While this might make sense at first, making a large 3.75pc positive position in his most attractive name also leads to many unintentional bets. Stocks B and C, which the manager also expects to outperform, have negative positions against the benchmark. Stocks F and G, which the manager expects to significantly underperform, have only small negative bets, limited to their index weight.
Once the short sale constraint is lifted, however, the manager can now scale his positions more closely to his insights. This results in making the same amount of active positions as the long-only portfolio, 7.5pc.
However, if the manager’s forecasted returns are realised, the excess return from the long-only portfolio would be 0.74pc, and the long/short portfolio 1.25pc. Thus lifting the short-sale constraint, can enable a portfolio to achieve higher returns for the same level of risk and insight.

Price: There has been a lot of coverage on 130/30 funds recently, most heralding the next participant into the market. This is understandable with some commentators suggesting the market in Europe for such funds will grow from €5bn to €50bn (£34bn) this year. I think the attractions are obvious for pension trustees and managers alike; long/short strategies (a term that covers other ratios other than just 130/30) are a natural extension of the equity manager toolbox.
The ability to short those stocks with a negative outlook can extend the alpha generation potential of the long portfolio. Get it right and it will outperform its benchmark. The introduction of parameters for the ratio of the long to the short brings in a required level risk management prerequisite for most pension trustees. Finally most 130/30 funds are structured with performance fees which immediately align manager and client which can only be a good thing.


Are there any constraints and/or barriers to investing in a 130/30 fund?

Kelly: From a fund manager’s perspective there are few major barriers to the investment of a 130/30 fund. The gearing aspect of the fund may mean that the fund has to operate with contracts for difference on the underlying stock positions.
However, this should still achieve the same effect for the same risk as would an underlying stock portfolio (i.e. share price movements will still be fully reflected in performance).

Adams: I believe the key consideration is governance, and the client’s understanding of shorting and leverage. 130/30 funds are likely to be used as a core equity strategy, and as such these key features and the associated risks need to be understood.
It is also worth noting that as with passive and enhanced index investing, the minimum separate account size can be higher than normal due to the need to hold the majority of stocks in a given index. This means pooled funds are likely to be the norm, making these strategies open to smaller clients.

Ball: Some pension scheme guidelines do not allow investments in leveraged products or funds that can take short positions due to concerns over volatility.
However, given the fact that 130/30 funds maintain 100pc net market exposure so that they do not increase overall risk, perhaps the biggest barrier to entry is lack of understanding among trustees.

Price: Inevitably there will be issues. There are several ways to run such a portfolio. The hedge funds that brought us the strategy tend to physically short stock and borrow through a prime broker using the proceeds to extend the long portfolio. The prime broker sells shorts, borrows to settle the position and then provide the extra positions of the long portfolio.
Alternatively regulated funds such as UCITS are prohibited from borrowing on anything but a temporary basis and therefore use derivative contracts to replicate the short positions. Both these processes may create a problem for a pension scheme if it has limits on borrowing or restricted use of derivatives. Even if such barriers do not exist, the scheme administration may not be up to the task of accounting for the short positions or derivatives.
A segregated pension scheme will have to look closely at how it accounts for a long/short strategy if indeed it can. It may consider holding a fund that will already have dealt with these issues.


What are the key points that pension schemes should consider when looking at this type of investment?

Kelly: With gearing there will inevitably come some additional risk, and schemes should recognise this. However, as indicated in the earlier question, this does not necessarily have to be a proportionate increase in risk.
More importantly and really in common with any other choice of investment, schemes must be careful in selecting their manager. Many managers who have a successful long only track record have absolutely no experience of shorting, and clearly shorting is a major component of the return potential of a 130/30 product. Managers should be questioned on their experience and any evidence that they add value through their shorting.

Adams: I see four key areas for pension schemes to consider:
• As discussed above, it is important to have an understanding of what short positions and leverage are, and their associated risks (as well as their benefits!). With increased investment in hedge funds by pension schemes, these areas are better understood by trustees than was once the case. However, there needs to be sufficient comfort with their use in core equity allocations.
• The experience of the individual fund manager (or team) in managing and implementing short positions is another consideration. Is this something new to them, or do they already manage short positions in other products?
• Does the asset management company’s infrastructure support the management of short positions? Do they have existing relationships with prime brokers and the necessary risk management procedures in place?
• Is the underlying investment process new or an extension of a proven existing process with sufficient focus on underweight/short positions? Some investment processes lend themselves better to 130/30 strategies than others, and the ability to generate negative stock views with the same research rigour as applied to positive views is a key consideration.

Ball: The key point to consider when looking at 130/30 funds is selecting the right fund manager. This is vital because investment skill remains the crux of the strategy’s success, just like in a traditional fund. 130/30 is an ideal framework for managers who really understand their markets and have the necessary expertise and skills for taking short positions, as well as long.
Not every manager has the appropriate investment process and experience necessary to take successful short positions. However, some managers have proven that their insights into potential underperformers are as powerful as those into potential outperformers. Relaxing the short constraint for those managers who are able to responsibly and successfully utilise short positions can result in significant gains in risk adjusted returns.
At JPMorgan, for example, we have pioneered the 130/30 approach in the US. Our US 130/30 Fund has, since inception (June 2004), delivered excess returns of 5pc pa*. (*Source JPMorgan Asset Management as at June 30, 2007. Performance is annualised and gross of fees.)

Price: The first is simple, the success of any long/short portfolio relies on the value add of the manager or quants model that is running it. Going short to extend long does not generate alpha it merely magnifies the alpha generation of the manager.
If the manager is underperforming a benchmark the long short will magnify this fact. If the short portfolio performs in absolute terms better than the long portfolio value will be eroded. Schemes should be looking to employ a long/short manager with a proven track record in such structures, maybe a proxy of an existing hedge fund managed by the candidate or a simulation based on market underweight positions of an existing process will suffice. What is clear is that relative out performance in the long only world may not be enough to ensure success in the long short world.
Secondly I think close examination of the risk management process employed by the manager is required. Theoretically a short portfolio can destroy value greater than the initial investment where as a long portfolio can only reduce an investment to zero. I am not suggesting that these two scenarios are remotely possible but never the less the short portfolio is a liability.
In a well managed long-short fund, the short should become marginalised by the out performance of the Long portfolio. In reality the ratio for example of 130/30 is only transitory; it is more likely to be 131/31 or 129/29 as market movements take effect. How the manager adjusts this, cash flow, periodic reallocation or ad hoc adjustment must be understood.
It may be appropriate to set barriers between which the ratio can move but if breached require a resetting to the optimal level, in this case 130/30. Again it may be more convenient to invest in a fund such as a UCITS where these criteria are preset and monitored, the risk management process being part of the funds authorisation criteria. Finally this is still a long equity portfolio and a scheme is still subject to the beta risk of the market even if some has been mitigated by an alpha generating manager.


Why, specifically, 130/30? Will we see investment models such as 140/40, 150/50 and so on?

Kelly: There is no reason in principal why 130/30 should prevail over 140/40 or any other balance between long and short. There have been some studies published by investment banks in the US that suggest that 130/30 is an optimal structure for achieving strong returns from short extension products without carrying undue risk.
However, I would see the major question for schemes investigating such a structure to be whether the gearing structure of 1.6x is an appropriate level of risk to carry, in which case 130/30 is the correct structure, and also how much confidence they have in the manager’s ability to pick shorts.
If they have more confidence in shorting capability, they may consider a more geared model.

adams: In many ways it is unfortunate that the label 130/30 has become the standard for this group of strategies. Many fund managers have tried unsuccessfully to have their brand or strategy name adopted by the marketplace, but we keep coming back to 130/30, which can be misleading.
The array of products offered by fund managers is certainly not limited to those with a fixed ratio of longs to shorts of 130/30; they already span a range of ratios. Indeed, a given product is likely to adjust its ratio over time in response to changing market conditions, so that, for example, it has a higher proportion of shorts when market volatility is low than when it is high.

Ball: After extensive research, the 130/30 approach is deemed to be the optimum. As short positions are added to a portfolio, exposure to a fund manager’s best ideas increases rapidly at first, but these benefits soon flatten out.
So 130 long/30 short is the sweet spot where the most efficient exposure to insights is gained.

Price: 130/30 appears to be the strategy among long short funds that provides the best results when measured against the technical indicators employed by fund managers.
I would suggest that the market for such funds is organic and that a certain ratio will become more common than others based on results. There is no reason why this can not be a 140/40 or a 120/20. The proof as always will be in the pudding.