Assessing 130/30 strategies
IPE asked three pension services - in Denmark, the Netherlands and the UK - the same question: ‘What is your approach to 130/30 strategies?' Here are their answers:
Ramon Tol, fund manager, equities, at Blue Sky Group, which manages several pension funds including that of KLM and has an AUM of €12bn
We do not believe in launching a search for 130/30 or similar strategies because first of all we want to find a skilful manager. Only when we have confidence in the manager and he or she has experience and skill in shorting, will we then discuss the opportunity of 130/30.
Overall we have 5% of our equity allocation in these strategies. We run two enhanced equity portfolios with a 130/30 extension on top because we believed the manager had the skill and experience in shorting. The relaxation of the long-only constraint is theoretically sound and very appealing. However, in practice it only delivers if the manager is skilful. We started the first in August 2006 and the second in May 2007.
One portfolio consists of US equities and the other concerns Canadian equities. So far most of these strategies have only been launched on top of US equities, although more providers are now emerging that also apply these to international equities. Nevertheless, shorting stocks in the US is still easier from a liquidity and cost point of view compared with, for instance, Europe.
The portfolio launched in May 2007 has done very well and is currently outperforming the corresponding long-only product net of fees. However, the one launched in the US in 2006 is doing worse than the corresponding long-only product.
The risk is that your underperformance is going to be bigger than the corresponding long-only strategy if the manager is not skilful enough or the underlying model does not work. But if the underlying model and the selection process work then this strategy is going to give you higher outperformance than long-only products.
Nevertheless, it is too early to draw any firm conclusions. You need at least 36 months of data before an information ratio is statistically significant. Further, we cannot ignore the fact that the summer of 2007 was a difficult environment. The credit crunch has had a substantial impact on most quant and thus 130/30 strategies, as about 80% of 130/30 strategies are run by quant shops. And it turned out that most of the quant managers were using the same quant factors, a practice know as ‘crowding'. It also had an impact on our 130/30 strategies though the influence on the total equity portfolio is limited because of manager diversification benefits.
From a manager selection point of view it is, therefore, very important to find the managers that are doing things differently from the mainstream quants, for example by having a more dynamic quant model or looking at more proprietary, perhaps yet undiscovered, quant factors to distinguish themselves from the competition. This is not an easy task. It means that quant managers will have to do further research and dig deeper. It probably also means they have to show less willingness to disclose the factors and methodologies they use in order to avoid others exploiting their model.
For pension funds it is important to have a diversified manager mix, including both quant and qualitative managers. For 130/30 that is going to be a challenging task, given the fact that most 130/30 managers are quants.
Shorting is not a new concept and has been going on for quite some time. Many institutional investors have adopted more aggressive strategies than 130/30, such as market-neutral strategies, long-short strategies or hedge funds.
So 130/30 is just an extension of an existing strategy; it is like dipping your toe in the ‘shorting' water. Often hedge fund-type strategies are being avoided because of high fees and due to the fact that they often promise alpha while - unlike 130/30 - actually only delivering a mixture of beta.
We are currently undertaking a large database research study in 130/30, which should help us make decisions on whether we should move more or less aggressively towards these types of strategies. We hope to have the results within a couple of months.
Nils Ladefoged, portfolio manager at PKA, which manages eight Danish pension funds that have a total AUM of DKK116bn (€15bn)
We currently have three long-short strategies: a 130/30 strategy for UK equities that we started in 2006, a 120/20 strategy for Japanese equities we added in 2007 and another 130/30 strategy for North American equities also added in 2007.
The differences between 120/20 and 130/30 are mainly the subject for a theoretical discussion. The investment manager was more comfortable with the 120/20 strategy for Japan.
Once you understand the theory behind taking short positions and the whole concept of extension strategies, 130/30 or 120/20 is simply just a natural step to take, as quantitative managers use signal source factors and a 130/30 strategy can get better exposure to those signals than a long-only strategy can. We specifically looked for a new manager for the 130/30 UK mandate, whereas for the Japanese and North American portfolios we hired the same quantitative managers we have had working for us for several years on long-only mandates, which we simply converted to extension strategies.
It is difficult to find the right managers for extension strategies because they require a lot of experience with shorting and dealing with prime brokers.
Unfortunately, the timing of moving to the extension strategies could have been better. We, like everybody else, did not foresee the quant deleveraging that took place last year and so the portfolios suffered because with 130/30 strategies investors get more exposure to the factors they want to bet on. In other words, with such strategies in place, when things go against you they get even worse.
There are two sides to this coin; when things are good, you will reap even higher rewards as we have seen some signs of in recent months.
But despite the slight underperformance in all three portfolios we still think it has been a good experience. We can clearly see that these portfolios are much more optimal than long-only portfolios.
However, the counterparty risk in these strategies is often overlooked. Investors use a prime broker to lend them shares, which they then short. In order to borrow those shares, investors must put up some collateral and initially we did not feel comfortable with PKA being in a collateral relationship with a financial institution. But we found some solutions where our counterparty risk is extremely limited and have had no problems.
Compared to long-only, short positions also present investors with the risk of a squeeze, in other words where they want to buy short positions and there are no sellers while the price continues to rise.
According to consultants we are so far the only pension fund in Denmark that applies a 130/30 or 120/20 strategy, although of course other pension funds have allocated to hedge funds with short positions.
Mike Taylor, chief executive at the London Pensions Fund Authority pension fund, which has AUM of £3.8bn (€4.8bn)
Currently we do not apply 130/30 or similar strategies to our investment portfolio because we are not convinced that they would be any better for us than long-only equity investments.
Indeed, we are happy with existing arrangements. Among the factors that have put us off are the very high fees and the lack of a long-term track record. In contrast to that, a long-only approach comes with a track record and has a better certainty of achieving returns at a reasonable price.
However, if the fees and the track record of this strategy were to change and become similar to traditional long-only equities we might look at 130/30 again. So, we will reconsider it again in the future if it attracts us but at the moment we are not prepared to even contemplate it, as we are unwilling to pay the fees of 2% of assets under management and 20% performance.
In addition to that, 130/30 strategies come with a different risk compared with long-only. You have to assume that your asset manager is just as good at picking shorting stocks as he or she is at picking ones that are likely to go up. And this, we feel, is a different skill-set and one that has not necessarily been demonstrated to date.
We are not even sure that these managers exist yet and are not convinced that 130/30 strategies offer higher returns than long-only equities.
The UK regulator does not forbid the use of shorting strategies by institutional investors. And so UK pension funds are looking at 130/30 because it is a relatively new product, which has been marketed quite heavily. I am aware that a number of them are also put off by the high fees.
The credit crunch has had an impact on absolutely everything. But we are not revising our investment strategy as a consequence of that. Instead we are just being more careful about who we place our money with, in particular when it comes to cash deposits. However, our overall investment strategy has not been changed because we are a long-term investor and believe that the credit crunch is a relatively short-term blip.
Interviews conducted by Nina Röhrbein