It is easy to see the appeal. After years of coming under pressure to provide alpha, long-only managers are being allowed to flex their muscles. 130/30 strategies, where a manager can invest up to 130% long while taking 30% short positions, have become all the rage.

It is no surprise then to see that a plethora of managers have launched 130/30 products, albeit with varying amounts of success. In March of this year, Merrill Lynch estimated that the industry was worth $50bn in assets. Now industry participants claim it is closer to $100bn.

Still, not everyone is convinced that there is enough demand for the supply. "130/30 is an opportunity for asset managers who got left behind on other products to re-invent themselves, and so they are creating the hype," says Dean Wetton, a senior consultant at PSolve.

Jim Connor, a partner at financial services consultancy Morse, agrees, "The best way to attract money is always to come up with something new. There is an element of that here." Like most observers, he argues that 130/30 strategies will succeed or fail on the basis of their performance versus fees. "There is a belief that if you take the handcuffs off a bit and reduce the constraints, long-only managers will be able to increase performance." As a result, managers can demand higher fees, aligning themselves more closely to hedge fund-type structures than long-only ones.

Merrill Lynch estimates that the costs of fundamental 130/30 strategies will slot somewhere between long-only and hedge fund products, while quant products will price somewhere between active index and long-only. "So for a management-only product, this might represent an increase in pricing of perhaps 1.5 times the long-only strategy," says the firm. For a performance fee product, it would still represent an increase, but a more variable one, with a performance fee based anywhere from 5% to 20% of gains beyond the relevant benchmark.

Given the higher costs and the lifting of restraints, Connor points out that an investor would expect to get 1.3 to 1.6 times the performance it was getting before, because of the leverage boost. This would make the fee structures justifiable. "Of course, that is assuming that you're delivering alpha," he says.

And therein lies the rub. Critics point to the lack of a real track record. Simulated returns assume that past performance and future performance can be reconciled, which is not the case, they argue. "In theory it sounds good, but I do not believe the process is symmetrical," argues Günther Schiendl, head of investments at APK Pensionkasse in Austria. He says depending on past performance is problematic. "I suspect that returns going forward will be different from what is being assumed. 130/30 products will have a slight long, mid or small cap bias because it's much easier to short a larger cap company than small caps. We have been having a small cap bull market for several years now, and it might go into reverse."


For his part, Wetton says investors need to look at what they are buying. "You have to think of fees in terms of what is the fee per expected active return. You have to look at what you're getting for your money. You can't just look at whether one fee is half the price of the other," he argues. If, on a long-only product, an investor expects to get the benchmark plus 3%, and that costs him 50 basis points, while on a 130/30 strategy he expects to get the benchmark plus 4% and is being charged 100 basis points, then, looking purely at active return over the fees, long-only is cheaper, he says.

Meanwhile, some investors are concerned about volatility. Nick Greenwood, pension fund manager at the Royal Country of Berkshire Pension Fund in the UK, says it is too early for his fund to look at the strategies. "At the moment people are just producing model track records, and the volatility is just scary. Some are swinging plus 2% and minus 2% per month. As the end user, I might be plus or minus 6% a quarter and that is not acceptable."

Indeed, many managers have suffered through the recent market volatility, seeing returns fall by as much as 8%, according to anecdotal evidence. Rick Di Mascio, chief executive of Inalytics, the performance measurement and transaction cost analysis firm, points out that choosing the right manager is crucial. "Shorting stocks is not easy, and our research shows that the average manager loses 100 basis points per annum through poor selling positions. And that's data from the long-only world," he says.

Not all long managers have the right experience. "There is evidence from some of the long/short funds that betas in falling markets are not the same as betas in rising markets," explains Simon Hill, senior investment consultant at Buck Consultants. "You have to be adding quite a pronounced amount of alpha to justify the higher fees - and on the fee basis it's not easy to see that these strategies are justified," he says.

But fans of the strategies argue that 130/30 funds can also bring risk benefits. Alan Brown, chief investment officer at Schroders, says he supports 130/30 strategies "not because it is an opportunity to leverage alpha particularly, but because it is a way of constructing more risk-efficient portfolios". In its March 2007 report, Merrill Lynch pointed out that some fundamentally-driven long-only portfolios bring with them industry-specific risks that a managers could neutralise by having the ability to short.

But many investors say the performance they are getting has justified the fees. Ramon Tol, an equities fund manager at the Blue Sky Group, manager of KLM Royal Dutch Airlines' corporate pension fund, says the fund's 130/30 enhanced mandate outperformed its long-only counterpart by 125 basis points in the year up to and including July. "There needs to be three years of track records before you can extract information about how valuable these strategies are. But I am cautiously optimistic."

Elsewhere Nils Ladefoged, portfolio manager at Denmark's Pensionkassernes Administration (PKA), says he expects there to be a "meaningful pick-up" in performance. The fund has invested $1.2bn in State Street Global Advisors' Edge strategies - the firm's name for its extension strategies. PKA seeded SSgA UK Alpha Edge last summer, and moved from SSgA Japan Active to SSgA Japan Alpha Edge this summer, which is a 120/20 version of the former. This year it is moving from SSgA US Index Plus to SSgA North American Index Plus Edge. PKA pays a performance fee, but declines to provide specifics.


In July, SSgA announced that it had reached the $10bn mark for assets under management in its Edge strategies. Rick Lacaille, European chief investment officer, says the target return for its strategies is typically double that of long-only, although the firm declines to provide specifics because of market sensitivities. "Our clients can opt for a fixed fee or a performance fee. The one thing that is important is that we have capacity constraints on all our strategies. If you sell a lot of 130 you can't manage as much long-only. We need to make sure we're rewarded in a similar way because it drains capacity," he says.

There is one thing that investors agree on. Manager talent is going to count for a lot. "The manager's market knowledge and skill in taking into account the costs and liquidity issues of short selling is a key driver of success. Having found a skilled manager for a 130/30 strategy the right price to pay should be based on the extra expected performance per unit of risk. Not all of the 130/30 products that are being offered meet these conditions," says Marc Nuitjen, head of external alpha mandates at Dutch fund PGGM.