A recent Morningstar analysis of much-hyped 130/30 strategies offers a chance to weigh up their performance. Joseph Mariathasan reports

The 130/30 concept appears to have originated in a paper published in 2002 by Steven Thorley, Roger Nmi Clarke and Harindra De Silva entitled ‘Portfolio Constraints and the Fundamental Law of Active Management'. The authors argued that the long-only constraint for active managers was the most punitive factor in effecting their ability to produce outperformance. So relaxing this constraint should, in theory, enable a substantial improvement in outperformance.

The paper appears to have been the catalyst for a rapidly growing phenomenon, explains Steve Deutsch, a director at Morningstar. "Following the paper, 130/30 products started in earnest in 2004, although many managers took products they already had and changed the strategy to allow limited shorting. The market built up in 2005 and took off in 2006. As of mid-2008, we see some $8bn (€5.7bn) in mutual funds, both retail and institutional, and over $80bn in collective trusts, separate accounts, and hedge funds."

More recently, Deutsch is seeing managers introduce 130/30 products as a defensive measure to ensure that they have a full complement of products for investors. He says: "Given recent market volatility, it seems intuitively attractive for managers to be allowed to short stock in choppy markets. At least for 2008, there will be a strong set of product offerings."

Deutsch has found that many managers experimented first with running 130/30 products in the unregulated sectors. "They have seen if the concept works with institutions in segregated funds or unregistered investment vehicles prior to launching retail mutual funds, which are now the more dominant form of product seen," he says.

As Angelo Calvello, an executive vice-president at Man Investments, explained in a recent paper: "These strategies are typically an extension of existing actively managed long-only portfolios. They generally use the same portfolio managers, research analysts, underlying investment process, portfolio construction methodology and trading as the original long only portfolios."

They also share key features with conventional long-only actively managed strategies which, as Calvello outlines, include the same investment universe and portfolio parameters as relative return strategies. Performance and risk measurements are calculated by reference to an equity benchmark and target beta is approximately 1.0.

The key differences are that they allow shorting, which means they have to use prime brokers and there is a limited amount of leverage through using the proceeds of the short sale to take the additional long positions with a 130/30 fund representing a fund that is 130% long and 30% short - although of course any other ratio is also possible.

Shorting stocks is not a natural extension of fundamental stock analysis, although it often is for purely quantitatively managed strategies. Long-only analysts and fund managers usually focus their efforts on those stocks likely to be the best outperformers, rather than diverting resources to identifying those likely to be the worst underperformers. Pure quantitative strategies do not have this limitation, but Deutsch finds 60-70% of 130/30 managers are not pure quantitative managers, and are either pure fundamental managers or use a mixture of fundamental and quantitative methodologies.

"Even if a manager has experience of shorting, how successful was he at the process?" Deutsch asks. "Having experience does not necessarily mean you are good at something."

Moreover, shorting stocks requires developing and maintaining relationships with prime brokers to be able to borrow the stocks required for short selling. The recent credit crunch and the demise of Bear Stearns has put immense strains on the relationships between hedge funds and prime brokers, and long-only managers will find themselves in a disadvantageous position as prime brokers cut their client lists to focus on their most profitable counterparties.

Paul Chew, director of research at Brown Advisory, a fundamental US equity manager, explains why his firm has a very negative view on the 130/30 route. "We do not manage 130/30 funds or long-short hedge funds. Our perspective is that it is important to do what you do well. Shorting stocks is a completely different discipline and can be very distracting from our perspective. It would have a big detrimental effect on our long-only process. But I can see that running 130/30 funds can certainly be tempting. A lot of mandates have been issued to people who have never managed portfolios in that way before."

Morningstar currently tracks 90 different money management firms offering 205 different distinct leveraged net long investment vehicles on a global basis, says Deutsch, and the number is growing. It has examined the information ratios, the outperformance of a manager divided by the tracking error.

The average information ratio for the US large cap blended strategies in their universe was 0.84. If 130/30 strategies did fulfil their theoretical potential, the expectation would be to see a significant improvement on this for the universe at large of 130/30 managers running the same strategy.

However, the results of the one-year period indicated that the majority of managers had information ratios lower than this, with a much smaller percentage achieving larger figures. "Leveraged net-long is supposed to be the superior method of managing money," says Deutsch. "Going long and short is supposed to have freed managers from unnecessary constraints."

If most of the strategies cannot produce an information ratio higher than the long-only large blend mutual fund category, these short-term results do not back the assertion that leveraged net long is the ‘new long-only'.

Moreover, the betas of many of the funds were significantly different from one, which surprised Deutsch. "These results on beta indicate that a key assumption about leveraged net-long, predominantly 130/30, is incorrect and reinforces the need for investors and their consultants or advisers to conduct their own due diligence and analysis of potential investments. It's both surprising and disturbing to see so many investment vehicles with such wide deviations from a beta of one."

If the results from 130/30 are not that spectacular, what is driving the enthusiasm for fund managers to introduce such products and proclaim their benefits with such gusto?

Fees may have something to do with it. 130/30 products represent a good example of the convergence between traditional and alternative worlds with fees lower than hedge funds but higher than long-only funds. Conventional managers are certainly incentivised to generate products which can utilise their existing capabilities and sometimes limited capacity to produce higher revenues, while hedge funds may see 130/30 products, even with lower fees, as accessing a much larger institutional marketplace than their traditional base of fund of funds and endowments. Calvello argues: "Many investors will likely find success with their investment in active extension strategies and, emboldened by this reward, they will broaden their search to include other, non-conventional strategies with higher alpha efficiency, even fewer constraints, more flexibility, and less traditional beta exposure."

Deutsch sees benefits to this process, especially in accessing more sophisticated strategies at lower costs. "Convergence is having a beneficial impact for investors in the form of widspread fee compression. That's why leveraged net long is presented as a revolution. It's not really a revolution. It's a natural, human evolution, the result of increased competition amonge traditional and alternative money managers for investor assets. Leveraged net long is just one more money management innovation in a secular trend of innovation, all driven by increased competition."

What is the future for 130/30 strategies? Morningstar's results are certainly provocative but a one-year time period is too short for any firm conclusions. A fundamental issue for investors to determine when considering 130/30 strategies managed by previously long-only firms is whether the fund possesses the required skills in identifying and managing short positions.

"Only time and actual results will tell," says Deutsch. "Back-tested results are very poor indicators of future performance. In three to five years there should be enough firm, actual performance to make stronger and definitive conclusions about whether leveraged net long strategies in general are delivering superior performance and are a legitimate revolution in the best interest of institutional and individual investors."

The 130/30 strategy may not even be the final destination warns Calvello. "130/30 strategies are not fully optimised solutions because they only partially maximise the value-added by relaxing the long-only constraint. Taking active extension to its logical conclusion takes us to an even less constrained strategy that could provide both greater value-added and beta exposure; a fully market-neutral strategy that eliminates the short constraint plus synthetic beta.

"This of course is the prototypical portable alpha solution. It is for this reason that I consider 130/30 strategies to be a step, a truck stop on the way to portable alpha strategies."