What is fuelling the rash of 130/30 products? And are they a legitimate relaxation of unnecessary constraints or a pernicious hybrid that combines the worst aspects of long-only managers’ asset-gathering philosophy and hedge fund-style fees? Joseph Mariathasan examines the drivers and drawbacks of 130/30 strategies
Are 130/30 products truly a way to harness a vast untapped potential of expertise that has so far lain undiscovered? Or are they just another fad, which, like all fads, may carry just a kernel of truth embedded within?
There is no doubt of the truth of the theory that expanding the opportunity set by adding short-selling capability should increase the potential for generating alpha. There is also evidence to indicate that - for traditional managers in particular - there may be a practical limit to the alpha that can be extracted through short selling, which is popularly seen as 30%.
But moving from a theoretical argument to the real world needs to take account of the very real obstacles in the way. Traditional active managers are not trained to undertake short selling at all, and there is therefore the danger that the risks will far outweigh the benefits in many cases. It will be the less sophisticated investors who will suffer, acting as a training ground for budding hedge fund managers in long-only firms who see 130/30 as a route to getting the short selling expertise required to move into the far more lucrative world of hedge funds.
A cynic might claim that 130/30 products combine the asset-gathering philosophy of long-only managers with fee structures modelled on the exorbitant levels demanded by hedge funds, creating a Frankenstein’s monster of a hybrid product that combines the worst aspects of both, ultimately benefiting everyone in the production process apart from the hapless end investor. This view may be extreme, but there are clearly developments that favour the promotion of 130/30 funds, not all of them in the interests of long-term institutional investors.
What is the ideal scenario in which 130/30 products make sense? This is where a traditional manager, focusing on long-only products, also generates a limited but strongly held set of views of stocks likely to underperform drastically. Being able to translate such views into actual trading positions should, in theory, increase the opportunity set within the manager’s investable universe. Setting a limit of 30% appears to hit a ‘sweet spot’ where the maximum gain for an acceptable level of risk is achieved.
Moreover, the ability to short 30% of his capital also means that the manager can leverage the long-only positions by 30%. In a 130/30 approach, the total leverage in terms of putting ideas to work would be 130% on the long side and 30% on the short to give 160%, as against a maximum of 100% in a traditional long-only approach.
This ideal scenario makes a number of assumptions, of which being able to generate alpha on both the long and the short side is clearly the most critical. However, the investment process also has to be amenable to adding on a short portfolio. The longer a specific short position is held, the greater the risk that the manager will face a short squeeze on that particular stock.
In contrast, investment processes with high turnovers are essentially making a high number of bets in a given time interval, and the value of any particular bet is correspondingly smaller. The shorter holding period reduces the risk of the manager being caught out by a squeeze on the stock. Managers with processes that require long holding periods for their views to be realised, may therefore be less equipped to go on to shorting stocks than those with much shorter holding periods. It may require more of a trading mentality to be able to short stocks successfully, which may be at odds with both the philosophy and the experience of long-term investment managers.
The manager must also have the skills to risk manage short positions. This is a skill few long-only managers naturally possess. The firm also needs to have established relationships with leading prime brokers to ensure they are able to borrow stock even when market conditions, as in July and August this year, may not be so favourable and prime brokers increase borrowing costs dramatically or even start calling back stock.
The ideal scenario is more the exception than the rule. It is clear that the growth of interest in 130/30 products has also been fuelled by other factors that are not in the best interests of investors.
Investment banks, of course, have been at the forefront of persuading fund managers to develop 130/30 products. But their interests are driven by the fact that they generate large fees from their prime broking divisions and prime brokers generate fees from lending stocks to hedge funds and 130/30 managers.
130/30 products, unlike hedge funds, are largely classed as mainstream equity products and therefore the potential size of investments by institutional investors is far larger than the amounts available for hedge funds in the alternatives bucket. However, the fee potential of 130/30 products is much higher than for long-only, so managers are highly incentivised to develop products with the very attractive characteristic of higher fees, but with no diminution of market size.
A key issue any long-only house has in managing hedge funds is the remuneration, and retention of key staff. This has proved to be the critical reason that many long-only houses have not been able to develop internal hedge fund businesses. Key staff find that, if they are successful, they can easily move to hedge fund of fund players willing to fund start-ups by experienced individuals in exchange for taking an equity stake in their management company. Running 130/30 products can be a halfway house for both the institutions and the individuals concerned. For individuals, persuading the institution they have the expertise to short stocks without launching a fully-fledged hedge fund is an attractive option when the eventual outcome may be to use the experience to move to a proper hedge fund and the remuneration to match.
Another trend is hedge funds offering 130/30 products as a direct route into pension funds’ equity allocations. The realisation that they can still generate performance fees with a 130/30 approach, even if their funds go down during bear markets, may stimulate an increased supply of hedge fund-managed 130/30 funds during long periods of static or declining markets. Moreover, 130/30 approaches can mask periods of relative underperformance in a rising market, while the negative absolute returns in an underperforming market-neutral product would be much more obvious.
The problem for an investor in a hedge fund-managed 130/30 product is how much attention the hedge fund manager pays to a product that, even with larger assets under management, will ultimately generate lower fees than those from the main hedge fund business. When it comes to another market crisis and a liquidity squeeze on shorted stocks, it will be the funds generating the most fees whose performance will be protected first.
Quantitative firms have been dominant in the 130/30 market as the nature of their investment processes - which essentially rank the complete universe of stocks with equal rigour - means that they are able to choose stocks that are predicted to underperform with as much confidence as stocks that are predicted to outperform. The same reasoning also means quantitative fund managers are natural managers of market-neutral equity funds. However, the issue for pension funds is whether the best investment strategy is actually to use quantitative managers to run 130/30 products or, if they really do have sustainable alpha generation capabilities, whether it would make more sense to use them in a full-blown market-neutral hedge fund and combine this with a swap to add alpha to whatever benchmark is required.
Quant funds have no inherent reason for stopping at 30% but are doing so primarily to satisfy the market demand. That is, they are driven by marketing rather than investment considerations. But this July and August showed that quantitative managers running any sort of long/short products have hidden risks that no one had been able to analyse or manage correctly. A large number of quantitative market-neutral funds, marketed as low-risk hedge funds designed to have a monthly drawdowns of 1% or less, simultaneously experienced drawdowns of 10% or more, reaching levels of 35% in a number of highly publicised cases. The reasons for this were predominantly the fact that the actual alpha they were able to generate was too low to be interesting for investors so that they had to use leverage of anywhere up to six times to produce a marketable return.
The market volatility was driven in part by the widening of credit spreads causing borrowing costs to go up and, with them, the costs of borrowing stocks to go short. As a result, many highly leveraged market-neutral quantitative hedge funds found themselves having to deleverage their portfolios, requiring them to buy back substantial amounts of short positions. The problem they appeared to face was not just that a number of quantitative funds were in a similar position, but that many had shorted the same stocks, so that the prices of these were squeezed upwards even though the signals from their models were telling them the stocks were still on the sell list.
The problems they faced are those faced by any manager who shorts stock. If a short position increases in value, not only does the fund lose money, but the relative weighting of the stock in the portfolio gets larger, so future losses become even larger in percentage terms. It is theoretically possible to lose the value of the entire fund and more through one position. In a long-only portfolio, the most that can go wrong with a specific stock bet is to lose the value of that position if the stock goes bankrupt. Moreover, if a fund shorts a stock that is being shorted by many other players, when it comes to closing the position, the manager faces the risk that many others may be attempting to do so as well. They may all be seeking to buy the stock at the same time, ramping up the price and giving rise to a ‘short squeeze’.
Controlling these types of risks is way outside the experience of most traditional long-only managers. As the experience of Goldman Sachs has shown, even the most highly regarded and experienced managers can struggle at times, with disastrous consequences of an order not likely to be seen in a long-only fund. While many funds subsequently recovered part of their losses, many were forced to deleverage and so were not able to recapture the losses when the market rebounded.
As the experience over this summer has graphically illustrated, many quantitative fund managers have models and approaches so fundamentally aligned, that in times of a liquidity crunch causing hedge funds to deleverage their portfolios and buy shorted stocks, the quant funds find themselves all buying back the same few stocks, driving up prices and increasing their losses.
So are 130/30 products just a passing fad or do they offer a real addition to a pension fund’s investment choices?
The truth, as is often the case, lies somewhere in between. They are an effective way for a small subset of managers to extend their universe for extracting alpha. There are certainly a few cases of traditional managers that have mastered the skills of short selling, and other cases of managers that are able to take occasional bets on shorting stocks to great effect. Whether they should be constrained to having a 30% short position at all times is a moot point. In many cases, they may well just be shorting the index as a whole and effectively having a leveraged position of 130% on the long side with which to generate alpha. Determining which managers can truly add alpha on the short side is difficult when the managers have no track record of experience. Quantitative managers have dominated 130/30 products so far but, in many senses, have the least reason to take a 130/30 approach of all. They can use the same alpha engine to manage a completely market-neutral fund that can be used to add alpha to any benchmark required through the liquid swaps market.
Investors are therefore faced with the unenviable choice of either going for quant firms that clearly have the expertise for 130/30 products, but have been shown to have undesirable and highly correlated drawdowns during periods of market crisis, or face the difficulty of finding a needle in a haystack - the traditional fund managers with real skills at short selling and the discipline to manage risk within that framework.
Perhaps the real challenge for institutional investors is to find the few managers that are genuinely offering a product that extends their skill set in a way that can be justified by an investment rationale rather than a marketing one.