A deluge of 130/30 funds flooded on to the market with the promise of escalating returns and a chance for managers to shine. However, bear markets have dampened performance. Frances Hughes examines the ups and downs of the 130/30 strategy.
When a flurry of 130/30 funds entered the market last year, many commentators questioned whether they signalled the beginning of the end for traditional long-only fund management. Commentators and providers alike heralded the concept as “the next big thing”. Since then, however, the market environment has changed dramatically.
At a crude level 130/30 funds are a combination of a traditional equity fund and a hedge fund. This is because they use a combination of long-only and long/short positions, 30% being the short portfolio and 130% being long.
To successfully manage such a fund, managers must demonstrate the ability to short stocks. The technique of shorting – particularly topical at the time of going to press – refers to a bet that a stock will drop in value, rather than go up.
In its simplest form, the concept of shorting consists of a manager borrowing a stock he thinks is overvalued. He then sells it on the open market. In the future, he must repurchase the stock and return it to the lender. His hope is that the stock he shorts will decrease in value. If he is correct, he can buy the stock back at a cheaper rate than he sold it – the difference between the price at which the manager sells a borrowed stock and buys it back is his profit – or loss, depending on the direction in which the stock moves. In a 130/30 portfolio the manager uses the cash generated from the initial sale of the shorted stock to add to his long portfolio – the stocks he thinks will go up in value.
The ideal scenario therefore, is for the shorted stocks to decrease in value and for the long positions to go up. The worst scenario is for shorted stocks to rise in value and long positions to fall.
However, just because a 130/30 fund shorts stocks it does not mean it is a hedge fund. On the contrary, there are big differences between the two. Like a traditional long-only fund a 130/30 portfolio maintains a 100% net long exposure for example. It is also linked to a market index and limits its short positions within a set boundary. Finally, unlike hedge funds a 130/30 fund is regulated under Ucits III.
Indeed, the reason there was an influx of 130/30 funds in Britain is the Ucits III powers that enable fund groups to use a wider range of strategies, including the shorting of stocks.The supposed main benefit of a 130/30 fund is the added freedom a manager has in expressing his views more fully and employing more conviction without taking much more market risk.
Because 130/30 allows managers to take advantage of all insights, the strategy relaxes some of the constraints of running a long-only fund.
In a long-only fund the most a manager can do to express his negative views on a stock is to not hold it. A 130/30 fund manager however, is able to short stocks he does not like and can attempt to make money from his negative views.
In addition, the money generated from shorting stocks is added to the long-only side of the portfolio – adding leverage to a manager’s positive views.
However, market conditions have conspired against the 130/30 concept since most of the funds were launched. In 2007 almost 40 funds entered the British market, according to Morningstar. However, not one of these with a one-year track record to September 5, produced a positive return for investors, it says.
Pete Fuller, a research director at S&P, says although the performance of 130/30 funds has been disappointing the concept is still a good one. He says the volatility in equity markets over the past year has made it hard for these strategies.
“It’s a good idea, but like all good ideas it has its limitations,” says Fuller. “The performance hasn’t been as good as one would hope. In rising or flat markets you can add value, but it’s very difficult in downward markets or markets which are all over the shop.
“In trendless markets, which you have at the moment, it’s difficult to have shorting strategies,” he says, “unless it’s very short term. But then turnover would rocket up and that’s a far higher risk profile than you bought into initially. It is an interesting idea but I don’t see people coming into the market until the world moves back to a sane footing.”
However, last year the enthusiasm for 130/30 funds, also known as alpha-extension, short-extension and hedge fund-lite, was far more tangible. Merrill Lynch for example, predicted that a “wave” of 130/30 funds would enter the market and further reduce the gap between hedge fund techniques and traditional fund management. It estimated that assets under management in 130/30 strategies could reach $1 trillion (£560 billion) in five years.
TABB Group, an American financial research and strategic advisory firm, went further by predicting that 130/30 strategies could reach $2 trillion in assets under management in three years. Meanwhile, Mercer estimated that £5 billion of British money would go into 130/30 strategies in 2007 alone.
The British investment market has indeed seen numerous launches of 130/30 funds. In the past 12 months to mid September, at least 30 have been launched, according to Morningstar.
As investors became more acquainted with hedge fund techniques and alternative investment strategies, sanctioned under the guidance of Ucits III regulations, fund providers were quick to soak up the enthusiasm.
In the first three quarters of this year alone, at least 15 130/30 funds have been launched, with more set to enter the market. However, figures from Lipper Feri show retail sales of 130/30 funds in Britain accounted for just €72m (£40m) in 2007. Meanwhile, retail sales across Europe including Britain accounted for €1.72 billion.
According to Lipper Feri, there is €3.39 billion of retail assets under management in 130/30 funds across Europe, including Britain, as of July 31. This signifies a fall, if only slightly, from 2007’s figure of €3.42 billion. Meanwhile, assets under management in Britain alone accounted for just €162m in July.
Indeed, it seems both the success and popularity of 130/30 funds was overestimated when the so-called “wave” appeared on the horizon. So much so, TABB Group says its estimate for assets under management in 130/30 funds globally has more than halved over the past 12 months. Its initial prediction of assets under management reaching $2 trillion in three years is out of reach, it says.
“That estimate is no longer realistic given the de-leveraging going on in the market and the flight to quality,” says Adam Sussman, director of research at TABB group. “It is probably less than half that.”
The disappointing performance of 130/30 strategies amid turbulent markets is also part of the reason. Of the 61 130/30 funds listed by Morningstar, 42 have one-year track records. However, not one produced a positive return for investors over one year to September 5. Instead, the average return over one year to September 5 was a fall of 20.85%, according to Morningstar.
The one fund that did avoid negative territory over that time is the DWS European Corporate Bonds 130/30 fund, which returned 0% over one year, compared with a decline from all of the remaining 130/30 funds with a one-year track record.
Groups that have introduced 130/30 funds within the past 12 months include Axa Rosenberg, Invesco Perpetual, Legg Mason, Pioneer, Resolution/Cartesian and SGAM. Fund providers that already offered 130/30 strategies for retail investors include JP Morgan and UBS. Groups expecting to launch 130/30 products include Threadneedle and Matterley.
Threadneedle, which already offers two 130/30 funds to retail investors, the Threadneedle American Extended Alpha and Global Extended Alpha funds, plans to launch further 130/30 strategies in the first quarter of 2009.
As reported in Fund Strategy, (September 8, page 7), Matterley, a boutique investment group set up in August, is launching a 130/30 investment trust, focusing on British equities, but with the added flexibility to invest in continental Europe. Matterley expects to launch the trust, managed by Henry Dixon and George Godber, by the end of this year. In addition, Principal Global Investors is understood to be considering a 130/30 launch, as is Standard Life.
Although fund groups have continued to launch 130/30 strategies, it is likely more groups would have entered the space if markets had not been so volatile and likewise, more investors would have invested in them.
But as for all funds investing in equity markets, the past year was particularly hard. The average return over one year till September 5 among all British equity funds listed by Morningstar declined by 13.67%, for example. The average return of European equity funds was a decline of 9.54%, while American and global equity funds have fallen by 2.2% and 5.57% respectively.
“Everybody’s been hit right now,” says Sussman. “Time will tell. It’s about how effectively [130/30] managers use their flexibility in order to deal with today’s environment.”
Because most 130/30 funds have been launched within the past 12 to 18 months, luck has not been on the side of this concept. To convince investors and IFAs of their merits, 130/30 funds must deliver good performance and build up strong track records, which is something they have been unable to do.
Last year F&C said it expected to launch further 130/30 funds following the introduction of its Enhanced Alpha UK Equity fund, but none have materialised. Richard Wilson, head of equities at F&C, says the market environment has delayed that debate.
The £43m F&C Enhanced Alpha UK Equity fund, managed by Peter Lees, launched on September 7, 2007. It is a fundamentally driven portfolio aiming to achieve long-term capital appreciation through exposure primarily to UK equities.
However, with a minimum investment of $1m, the fund is firmly aimed at institutional investors. Wilson says it was not intended for the retail market.
“That would be a much later stage,” he says. “It’s quite a sophisticated product. It [the F&C Enhanced Alpha UK Equity fund] is for institutional investors wanting to move into higher alpha. It’s primarily a substitute for the existing long-only managers.”
However, other groups have launched 130/30 strategies for the retail market. Of the 130/30 fund launches listed by Morningstar in the past 12 months, at least 13 have minimum investments of £5,000 or less. The funds available to retail investors cover the British, American, European and Global markets.
The £37m Threadneedle American Extended Alpha fund for example, was launched in October last year. Minimum investment is £1,000. Managed by Stephen Moore, the fund aims to achieve above-average capital growth by investing in long and short positions within North American equity markets.
Since launch to September 8, Threadneedle American Extended Alpha has produced a return of 0.85%, compared with an average Investment Management Association (IMA) North America sector fall of 5.12%. This ranks Robeco 130/30 European Eq -4.19 63 01 Aug 07JPM Europe 130/30 -12.5 303 25 Jun 07DWS Invest European Eq 130/30 -15.19 373 20 Jun 08JPM Europe Slct 130/30 -15.19 374 25 Jun 07Cominvest 130/30 Europe -16.81 395 02 Jul 07Mean/Count -9.54 424JPM US Slct 130/30 (A)-USD -0.82 102 05 Jul 07UBS US 130/30 Eq -5.76 201 9 Jul 07JPM US 130/30 (A) USD -6.28 213 2 Aug 07Mean/Count -2.2 259 it eighth out of 77 funds in the sector.
The Threadneedle Global Extended Alpha fund, which is managed by Andrew Holliman, was only launched in July. Since launch to September 8, it has produced a fall of 2.65% compared with an IMA Global Growth sector average of 2.48%.
However, Ian Annand, senior product development manager at Threadneedle, says it is too early to analyse fully the 130/30-type structure against the performance of a traditional long-only fund. Indeed, it is a relatively short time since most 130/30 funds were launched. Annand says turbulent markets, lack of education and limited acceptance in the British retail market have all had a part to play.
“There’s no surprise in a difficult market these funds haven’t attracted as much investment as people had hoped,” he says. “And therefore there’s been less of a push into the market. It will take a while to educate people in the benefits of them. They are much more widely marketed and accepted in the States. [But] It will take longer for them to be accepted in the mainstream here.”
Indeed, 130/30 funds are more established in America than they are in Britain. In America these types of funds have been managed for the past five or more years. Nonetheless, they are still primarily used by institutional rather than retail investors.
In contrast to the British market again, the majority of 130/30 strategies in America are quantitatively driven, rather than being qualitative in their approach. Sussman of TABB Group, based in New York, says a mixture of regulatory and cultural concerns are behind that. The American market has always been more comfortable with quant funds that British investors have.
The Matterley 130/30 fund for example, which is expected to be launched next month, is fundamentally driven. It will be a focused portfolio of between 40 and 50 stocks, says George Godber, a fund manager at Matterley. He says quantitative analysis will be used in the fund, but it will be limited.
“There are a lot of things quant doesn’t pick up,” says Godber. “We are very balance sheet-focused [and] we are trying to get to the true value of what a stock is worth.
“This fund can offer a greater degree of capital preservation, compared with a standard long-only fund. That’s the big challenge for us,” he says. “I don’t think anyone’s done very well yet.”
“For us, we don’t care what weighting anything is in the index,” Godber continues. “We’ll look pretty foolish if we underperform it, but we’re willing to move away from it. It doesn’t worry us to be forced to add money into our highest conviction stocks.”
Sussman of TABB Group agrees. He says the 130/30 structure forces managers to back their convictions and magnifies every decision they make.
“That’s why it’s such a good product,” Sussman says. “You don’t get to hide. It allows those people that are good to shine and it will expose the weaknesses of those that are not. It accentuates everybody’s decisions [and] it puts additional onus on everyone.”
So who is best placed to manage a 130/30 portfolio? Having experience of running hedge funds or usingderivatives is one advantage, in that the manager will be familiar with shorting.
After all, shorting stocks requires different skills to long-only investing. At the least it requires managers to look at the whole market, including stocks and sectors they do not like. But the ability to identify overpriced stocks is one requirement. The other is managing risk.
Fuller at S&P agrees. He says it involves a different way of thinking. “It’s very difficult for a long-only manager to get his head round it,” he says. “To short [a stock] you’ve got to have the conviction it’s going to go down. It’s a different state of mind.”
To cover the whole market as a fundamental 130/30 manager a group will need a strong research team behind it. In addition, a fund group with an in-house brokerage desk or established links with brokers will be better placed to conduct the short trades more smoothly. “When you short a stock you need brokerage,” says Fuller.
For this reason he says large investment houses with strong research teams and large trading desks may be at an advantage when it comes to 130/30 strategies.
“It’s not the opposite of long-only investing,” says Fuller. “You’ve got an awful lot of research to do. You’ve got to cover the whole market. We like to see large groups with big research teams and strong trading desks or experience of using a prime broker. That’s very important when you’re shorting. You don’t want to move the market. You have to have sophisticated dealing facilities.”
Although Fuller says he would not disregard a small or medium house, he says there is comfort in a large team with both investing experience and trading experience. “Personally I’d like to see companies with a strong fixed income team [running 130/30s],” he says. “They seem to know what they are doing with derivatives.”
Last year Baring Asset Management entered the 130/30 space with a fundamentally driven, fixed-interest 130/30 fund. However, it is firmly aimed at the institutional market.
Alan Wilde, the head of the fixed income and currency team at Barings, is manager of the fund. He says the group has considered bringing it into the retail space, but decided to wait for a catalyst before it does.
“I think it has application for the retail market,” Wilde says. “We don’t regard it as a big stepping stone. Conceptually it’s the same as it is for equities in that you can express negative views, but in application it’s different.”
And perhaps this is the important thing to note with regard to 130/30 funds. The application of the strategy is different with every fund. Not only does it depend on the ability of the individual managers to effectively work the long and short split, but also the way it is implemented can vary greatly.
A 130/30 fund could use a 130/30 or a 110/10 split for example. It could use more leverage or less, decreasing exposure or increasing it and it can be managed on a purely fundamental basis or a quant basis.
These are just some of the questions investors need to ask, but until there are more robust track records for 130/30 funds and until the financial markets become less volatile, there may be fewer investors willing to pose them than there were last year.
Sussman at TABB Group admits it will take time. “They [130/30 funds] will continue to gain market share and become more established in the retail space, especially in the context of alternative investments,” he says.
“The long-term trend is that investors are looking for products that allow managers better control over exposure and risk. And that’s the true value of a 130/30 fund. There is a greater deal of flexibility. It’s a long-term shift,” he adds. “Once investors become more educated about what the product is and managers have a consistent message, more investors will want to invest in them.”
The fact that 130/30 funds have so many different names highlights their infancy. It also points to the confusion surrounding them. Although they are still in the early stages of development, the consensus is the concept will become more prevalent in the investment universe – but this is likely to take much longer than initially thought.
What the experts say
Gary Potter, co-head of multi-manager at Thames River
“There has been a lot of euphoria about 130/30 funds. But they have been somewhat cast aside. As a concept it came as a fad and then went. The new type of absolute return funds took over and particularly in these markets, are a much more dynamic area. Our overall concerns [with 130/30 funds] relate to the managers who are operating them. Not many of them understand the short book. Cartesian are an isolated exception.”
Tim Cockerill, the head of research at Rowan
“The way they are approached does vary. My initial thought was they look interesting. But I want to see how they behave first and so far performance has been mixed. It is still a possibility we would use them but particularly in these markets I am reluctant to jump into anything new. Now might not be the right time to be adventurous with strategy.”
Meera Patel, a senior analyst at Hargreaves Lansdown.
“Investors and IFAs should pick carefully. We don’t think fund managers should launch these funds if they do not have a skill in shorting. Cartesian is one of the few that do. It [shorting] requires a completely different skill set.”