As the appetite for short extension funds grows among mainstream investors, the battle lines are being drawn between the quantitative and fundamental camps. Of course, both argue their case eloquently and each is convinced that they have the right stuff to manage these long/short strategies. In the end, performance will be the judge but at the moment track records are short and information difficult to unearth.

In fact, only a handful of managers have run 130/30 strategies for more than two years - and only one or two for more than five years. The majority of these are based in the US, although they are likely to gain traction in Europe thanks to UCITS III, which allows managers to short stocks via derivatives. Although they are too new to have established a consistent performance history, 130/30 strategies as a whole have performed well when compared to both hedge funds and the S&P 500 by a notable margin.

One of the main benefits of the strategy is that it loosens the long-only constraint and enables asset managers to sell short, thereby profiting from a stock that drops in value. In a 130/30 fund, this translates into 30% of assets being invested in a short portfolio while 130% is invested in a long portfolio.

As with any debate, the case is not black and white, although it is easy to see why quantitative managers think they have the edge. After all, they have a lock on the market, accounting for about 80% of the $50bn-60bn of assets that have been pouring into 130/30 funds, according to industry estimates. This is no surprise, as they were able to leverage off their years of experience in the hedge fund industry, which has a long history of using shorting techniques. Many quants viewed 130/30 as a natural extension to their business and a prime opportunity to mine a new seam of clients.

“Institutions want to deal with managers who have experience,” according to Rick Lacaille, chief investment officer Europe at State Street Global Advisors, which (as of July), has amassed over $10bn in assets under management in its range of Edge strategies, State Street’s version of the short extension approach. “By nature, quants are designed for shorting. It is a symmetrical process that looks at the whole universe and divides it into cheap and expensive stocks. The fundamental approach is typically focused on picking the winners, which is a very different skill set than shorting stocks.”

David Blitz, head of quantitative equity research at Robeco Asset Management, which recently launched its UCIT III-compliant European 130/30 fund, adds, “Quantitative managers make use of forecasting models that identify both outperformers and underperformers. With a 130/30 strategy, the fund manager is better able to take advantage of this information than with a traditional long-only strategy. The step towards 130/30 is less natural for fundamental managers, because they are specialised in selecting, for example, 100 winners from a global universe of 2,500 stocks.

“In the case of a 130/30 strategy, it is also necessary to select the biggest losers from the 2,400 remaining stocks for the short portfolio. This is not something that a fundamental manager can easily include in his investment process, as this requires extra efforts and a different type of investment expertise.”

Fundamentalists naturally refute their lack of shorting capability and argue that they have the acumen to choose stocks to short. Although few would openly gloat, they do point to the hammering quant-driven hedge funds and short extension funds suffered in July and August during the unfolding sub-prime crisis. According to figures from Morningstar, a US-based provider of research and ratings, for periods ended 14 August, the average gross performance of 155 long/short equity and market-neutral mutual funds was -2.08% for the month, -3.3% for the quarter and 1.02% for the year. Even the top-quartile return for the month was negative: -0.55%. Returns for the first two weeks in August ranged from 3.99% to -6.98%.

A variety of factors conspired against the quant model, including crowded trades, unexpectedly high correlations and shifts in trends. For a number of funds, the sell-off was not due to fundamentals, but deleveraging and cash-raising activities in the hedge fund space. For 130/30, computer models struggled to cope with the volatility. Industry participants note, though, that it is still early days and a cautious optimism now pervades as liquidity has returned.

Manolis Liodakis, a director and head of European quantitative research at Citi, notes, “The worst affected have been those who used significant amounts of leverage, such as market-neutral funds. But many of the quant models have rebounded since mid-August. I think what we will see, if the current market conditions of high volatility persist, is that short-extension funds particularly under UCITS will take on less leverage.”

Despite the recovery, fundamental managers are hoping that the quant community’s recent fall from grace will strengthen its case for 130/30. Luke Newman, who co-manages the newly minted F&C Enhanced Alpha UK Equity fund, believes that the fundamental approach will lend itself better to the European context. “If you look at the US, there is a bias towards quant solutions because they can work in broader indices with a more even distribution of stocks in terms of size. This is not the case in the UK, for example, where the top 15 stocks account for well over 50% of the market capitalisation of the FTSE All Share Index - this skew provides opportunities for active managers. Within the UK we have demonstrated that with a consistent bottom-up stock-picking approach it is possible to consistently outperform the market - and the Enhanced Alpha fund builds on this experience.”

Newman explains that F&C is applying the ‘lifecycle’ investment approach that it uses in its traditional long-only funds. This means targeting companies that are either set to benefit from a recovery or restructuring phase, a period of growth, or those that have the ability to reallocate cash flow to more profitable areas of business. “We discard a lot of information that we gain as part of this process and now we can short the companies that we term faders, which means that they are structurally challenged.”

Paul Quinsee, chief investment officer at JP Morgan Asset Management is a veteran in the field, having launched its US large-cap core equity fund in 2004. He believes that a fundamental approach enables managers to drill down deeper into a stock. “In a long-only approach you rarely get a chance to express insights on which companies are unattractive because they are relatively small against the benchmark. We have built a 20-year history of researching companies and we can now use that experience to short stocks. Our recent successes include stocks in the home builder, financials and basic materials sectors.”

Although there is a clear-cut dividing line between many quant and fundamental houses, it is beginning to blur. Some fund management groups, such as Fortis and Henderson, are creating hybrid strategies that combine both disciplines. Says Karine Jesidowski, head of research and development at Fortis, which launched its 130/30 Euro Strategy fund this April, “We really do not have a firm view on the quant versus fundamental debate. We use a mixture of both in that, for the 100% portfolio, we use our proprietary quant model based on a fundamental indexing theory. This means we do not look at market cap but things such as dividend and net income. For the 30/30 long/short portfolio, we apply fundamental analysis. The big question to ask, though, is does the fund manager have experience in shorting?”

Nicolaas Marais, head of active equities, Europe at Barclays Global Investors, agrees, “Investors should step back and ask what will make the manager successful in the space. At the end of the day, you need good stock selection in both cases. I would never venture to say that fundamental analysts can’t do it. There is no magic bullet. However, the quality of skills of the manager will be greatly magnified in a 130/30 fund by the generation of alpha, or lack of it, via the short portion of the portfolio.”