Taking off for new horizons
Pension funds are the main institutional customers for 130/30 strategies and, to date, most of the interest has been in the US. Here the pace has been set by CalPERS, the California Public Employees' Retirement System.
Earlier this year, CalPERS switched its $6.7bn (€4.8bn) global fixed income portfolio to a 130/30 strategy. This, as its consultant Wilshire noted, was a bold move, since 130/30 strategies have hitherto been applied to global equities, where more alpha is available.
Now European pension funds have begun to show an interest. AP3,one of Sweden's buffer funds, says it is considering a move from enhanced indexation to a 130/30-type strategy. In the UK, the pension fund of supermarket chain Asda has put £165m (€236m) of its assets into a 130/30 strategy for global equities.
Yet most of the European interest in 130/30 strategies has been concentrated in the Netherlands, with its reputation for financial innovation. Pension services provider Blue Sky Group, whose main client is the pension funds of KLM Royal Dutch Airlines, has been in the vanguard.
Blue Sky Group, which has €12bn in assets under management, was one of the first European investors to turn one of its enhanced mandates into a long-only extension. In May it announced that it planned to move its entire €4.2bn passive global equity portfolio into 120/20 or 130/30 strategies.
Ramon Tol, fund manager equities, responsible for manager selection and monitoring at Blue Sky Group, set out the reasons for the group's adoption of extension strategies at the Investing in 130/30 Funds 2007 conference in London in September: "Our initial objective was, first, to achieve a higher information ratio and a higher alpha and, second, to try to use more of our risk budget which is currently not being used by the active managers."
The reason is the historically low cross-sectional volatility in the market, he suggests. "This is a very difficult environment for active managers to add value and a lot of our active managers are not even using 50% of their risk budget. So we feel this is a way to use more."
Another reason for adopting 130/30-type strategies is to achieve better diversification, Tol says. However, there are caveats. "If managers use short proceeds to lever up long-only ideas it will lead to a more concentrated rather than more diversified portfolio. Levering up long-only bets and using shorts as a funding source is something we do not really like."
There are also sound conceptual reasons for venturing into 130/30 strategies. Two concepts underpin the rationale, says Tol. One is the Fundamental Law of Active Management, which states that the information ratio from active management increases with the square root of breadth available to the manager.
The other is the transfer coefficient, a measurement that enables asset managers to quantify the extent to which their alphas are being absorbed into their portfolios. Rather than simply judging performance by manager skill, transfer coefficient assesses the risk-adjusted correlation between the active weights in the portfolio and the alphas.
All the evidence suggests that moving from long-only to a 130/30 type strategy results in a 50% increase in transfer coefficient, Tol points out.
Further weight has been provided by the idea of ‘active share'. This is a new measure that assesses how close a fund is to its benchmark. Research by Antti Petajisto of Yale University and his colleague Martijn Cremers has found that funds with higher active shares are more likely to outperform their benchmarks.
"This is an interesting finding because this says that higher active share leads to outperformance, and extension strategies by definition result in higher active share." For Tol, skill or the information coefficient (IC) is the sine qua non of 130/30 strategies. "Skill is of crucial importance. The entire strategy of 130/30 only works if the manager is truly skilful or, to put it differently, if the IC is positive."Can the skilled manager add value by shorting? That's the crucial question. We want to see evidence that the manager can."
Blue Sky uses independent consultant software to identify skilful managers. "Managers can provide any analysis of performance they want. We prefer independent evidence and consultant software gives us a better feel for a manager's shorting skill sets."
"We do two things. We look at the 12-month rolling IC of the components of the managers' quant models - a growth model, a value model a sentiment model and a combined model. From that we can see if the IC is positive or if it has decreased.
"We also try to identify skill by looking at the value added of a manager's overweights and underweights. Where does the value come from? Is it from the overweights or the underweights?
"What you generally see with long-only managers is that they generate a lot of value added in their overweights but destroy value in their underweights. A positive contribution from overweight decisions is often insufficient to offset value destroyed in underweight and neutral positions."
Blue Sky Group adopts an unusual approach to selecting 130/30 managers, Tol says. "We first select the managers and then determine if they can run an extension strategy. We want to know for sure if the manager is skilful. If the manager is skilful, and we are convinced that he is, then we will consider 130/30.
"What we will not do is launch the 130/30 search and look for a 130/30 manager. We turn it the other way around, because we believe that a skilled long-only manager might achieve better results than unskilled 130/30 managers."
Tol has carried out his own study of 130/30 manager performance, looking at the net returns of managers with both long-only and extension products. "The results are mixed but encouraging," he says "All of the managers who showed a higher information ratios in their extension strategies also showed higher alpha. And that is exactly what we are looking for."
Blue Sky Group has chosen funds rather than segregated mandates as vehicles for its US and Canadian 130/30 strategies. The main reason is inexperience in dealing with prime brokers, says Tol. "We have no experience at all in negotiating with prime brokers, so they can set whatever prices they want. Using a fund means that we don't have to sit down with the prime broker and discuss setting up contracts about all kinds of fees and collateral."
Yet there are disadvantages in funds, he says "Monitoring underlying positions and using that in consultant software is more difficult. Another drawback is the inability to generate securities lending revenues. "In the US securities lending revenues are not at all interesting, so using a fund does not matter. But in Europe we generate between 10 to 15 basis points on securities lending each year. So if we found a skilful European manager we would prefer a segregated account."
Tol says Blue Sky Group would probably look to asset managers for advice when negotiating with prime brokers. "I'm not sure that we would use consultants."
The performance of extension strategies to date has been encouraging, Tol says. Blue Sky Group's US large caps 130/30 strategy, developed from a long-only mandate, has achieved 86bps of added value on a net basis since August last year.
Blue Sky Group also hired a Canadian large cap enhanced manager in June this year who already had a 110/10 strategy in place. So far, that strategy has outperformed its long only counterpart by 35bps.
"So far so good, but the track records are way too short to draw any strong conclusions," says Tol.
Future allocations to 130/30 strategies may mean increasing the tracking error available, he says. "It is important to bear in mind where 130/30 strategies are most efficient. Is this in the low tracking error space or the high tracking error space? This is important for us because of our core-satellite approach. This means we cannot go any higher than enhanced.
"If 130/30 is most efficient in the higher tracking error space then perhaps we should consider moving within our core to higher tracking error strategies, if that is where we get the biggest increase in the information ratio."
Simulations by researchers suggest that the largest percentage increases in the transfer coefficient occur when tracking error is higher, he points out. "This makes sense because the long-only constraint becomes more binding the higher the tracking error."