Some 130/30 funds have failed to live up to expectation and as investors begin to look elsewhere for sources of alpha is the writing on the wall? Giovanni Legorano investigates
Designed to generate more alpha from a portfolio than is generally possible with a long-only fund, 130/30 products have initially attracted strong interest from the pension funds community both in Europe and North America. However, observers do not share the same views on whether the interest in short extension products lived up to expectations and generated sizable activity for 130/30 funds’ providers.
Market turmoil has put great pressure on active managers and, as a result, short extension funds struggled in such a challenging environment. Adding to it, even in healthier conditions there was widespread scepticism of the suitability of these kinds of investments.
Rick Di Mascio, chief executive and founder of Inalytics, pointed out 130/30 equity funds attracted the interest of pension funds because they represented a softer introduction to the world of hedge funds and shorting. However, he said: “The results of a lot of those funds have not been particularly good. So, while there is a sense some of them have delivered, it has been quite difficult for pension funds to adopt a new strategy when the results haven’t been brilliant and most investors’ inclination is to be risk-adverse.”
Being mostly managed by quant managers, who had been under heavy pressure since the summer of 2007, Di Mascio argued it had been difficult to separate whether the 130/30 strategies were intrinsically inadequate or whether their problems were a pure reflection of the quants’ woes. He added: “We started to see the introduction of what are known as fundamental houses [managers who are running 130/30 funds not on a quant basis, but on a fundamental stock picking basis], but those funds are still low in number relative to the others. One of the problems with 130/30 is clearly that a lot of the early managers tend to run them as an extension of their quant portfolio and the quant strategies had a very difficult time.”
As to the measurement of their performance, Debbie Clarke, principal at Mercer, noted that the set up of several of these funds as ‘paper’ portfolios made it a challenging task. She explained: “A lot of managers were running these funds alongside their long-only strategies, but only as ‘paper’ portfolios, they were not using real money. Funnily enough we have not seen the actual performance of these funds; we suspect a number of them were quietly dropped, as their performance was not as good as had been expected.”
Nonetheless, there are clear cases in which the level of fundraising reflects an existing and continuing interest in 130/30 products by pension funds and institutional investors at large. Simon Vanstone, Europe CEO of Axa Rosenberg, said its short extension funds raised over US$2bn in the last two years.
Vanstone pointed out there were examples of 130/30 strategies which did not meet expectations due to the risk environment, but that bottom-up stock-selection strategies, both on the long and short side, were less affected. With regards to due diligence by pension funds, he said: “An important aspect to consider is whether the investor is comfortable that the manager can deliver alpha and add value both on the long and short side and, very importantly, has a track record of doing that. The second main aspect would be to have the track record to be able to manage the short side of the relationship, namely the prime brokers.”
Indeed, Will Cazalet, director of global long/short equities at Axa Rosenberg added pension funds had to decide whether they wanted to be autonomously responsible for the due diligence of the prime broker or they left it to the responsibility to the manager.
Giving a pension fund’s perspective on due diligence, Ramon Tol, fund manager, Blue Sky Group, highlighted next to implementation and risk management skill, skill and experience in shorting as important for a 130-30 fund (long only extension strategy). “Adding value in the shorts seems to be essential for a 130-30 strategy to work.” He added: “Alternatively, if fund managers without or limited track record in shorting enter shorting space, pension funds could judge them on the basis of an analysis of the value added of the underweighted positions in their long only products. If they manage to add value in these stocks, then there is a better chance they will add value in shorting as well, since the underweighted stocks are the most likely candidates for shorting.” However, this does not take into consideration the tail risk you are introducing when shorting stocks. The shorted stocks are usually the smaller cap stocks and tend to be much more volatile than larger cap stocks. Fund managers need to be aware of this.
The road to 130/30
So far, pension funds are more familiar with equity 130/30 funds rather than fixed income.
The California Public Employees’ Retirement System (CalPERS) was one of the first pension funds to invest in this kind of strategy in the bonds’ space.
Alan Wilde, head of fixed income at Barings - one of six managers appointed by the US giant pension fund in 2007 to run short extension fixed income mandates – said both pension funds and consultants needed more time to become comfortable with the concept of 130/30 fixed income funds, especially in light of 2008’s severe dislocation of markets.
In terms of advantages for pension funds, Wilde said these strategies introduced the investor to some hedge fund techniques, but with complete transparency. Using the example of the currency investment dimension, he added: “Without a 130/30 symmetry typically you could only really make any money by expressing a short position on a few currencies such as, the dollar, which have a high index weighting, but you could only make money by having a long-only position in currencies with a low index weighting. Without the flexibility of 130/30 it is not possible to express a meaningful short position on currencies such as the Australian dollar. It simply works by using the leverage on the long side to offset the short positions to maintain a 100% net asset value (NAV) invested position.”
Wilde believes that, as far as the fixed income space was concerned, short extensions do not represent a huge step from the considerations that a fixed income manager would ordinarily make in his day to day decision making.
Comparing the equity space to the fixed income one, he said: “For equities it is a much more one-dimensional portfolio management, while with fixed income you can have at least five different dimensions within which you can express views on market movements. Global fixed income managers implicitly make these decisions every day.”
Beginning of the end
Many have pointed out the strategy of these funds represents only a modest step away from what pension funds would require a long-only fund manager to do. However, as they are trapped between traditional long-only funds and long-short portfolios, some doubt 130/30 funds will still have a place in the investment environment.
Mercer’s Clarke said: “I don’t think there is much of a future for these strategies, judging from how things stand at the moment. Many clients saw these funds as a stepping stone towards investing in long-short strategies. But if clients can gain confidence with shorting and identify managers with the right skill set we would expect them to go straight to investing in long / short strategies.”
In addition, many observers argued fees have been a contentious aspect since these funds’ inception. According to Tol the management fees seem to be more in line with the management fees for long only mandates and at least not as expensive as the fees hedge funds typically charge. Tol argued that one could compare the expected (as indicated by the manager) alpha of the long only product with the expected alpha of the long only extension product.
He explained: “You look at the expected alpha for the long only and for the extension strategy, calculate the difference in the expected alpha in going from the long only to the extension and then compare that with the increase in fee in going from long-only to extension. This could be a starting point to make a judgement on fees.”
Dismissing the idea these funds would disappear, Cazalet said the issue would be whether managers could deliver a higher alpha with a marginal additional level of risk.
In the same line, Tol said that active managers struggled in terms of relative performance as a result of huge volatility.
He said: “130/30 strategies are a form of active management and many of these strategies suffered in the last two years, but that probably applies to active management strategies in general. Many institutional investors are moving out of active strategies into passive ones. If the above illustrated market prevails for one or two more years, that could be devastating to the whole active management industry.” Tol adds: “The impact on the Blue Sky Funds is only limited since we are very critical of active investing; passive/enhanced mandates for the most efficient markets and active mandates only for less efficient, less liquid markets”.
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