Amid the enthusiasm for the 130/30 concept, there is a general recognition that 30% is not necessarily the optimal level for the short component. Hugo Greenhalgh reports
It is a question that many fund managers consider the Holy Grail of investing: just where is the ‘sweet spot' when the risk profile combines with market exposure to produce optimal returns? The issue has become particularly pressing with the launch of a rash of a new style of long/short funds known as 130/30. The strategy is fairly simple, combining a traditional long-only portfolio with a 30% long/30% short portfolio to produce alpha more efficiently.
This ability to short the market - selling down those stocks likely to underperform - has been shown, at least in theory, to boost performance substantially by effectively leveraging the underlying returns.
But why 130/30? Is there any particular reason why this should be seen as the optimal point? Just three years ago California-based investment house Analytic Investors put forward its case for adding a short overlay to a long strategy to maximise returns. "Investors do not need to relax the long-only constraint completely in order to reap substantial benefits," wrote the authors, Roger Clarke, Harindra de Silva and Steven Safra, all senior members of the firm. "Relaxing the constraint by just 10% to 20% can be advantageous."
Table 1. Public managers and trust banks offering 130/30 products - an informal survey
So advantageous in fact that pension fund, like CalPERS (see table 2),have been early adopters of 130/30 funds, and pension funds are estimated to have invested up to $50bn already. A recent Merrill Lynch briefing on 130/30 funds estimated up to €1.25trn is set to flow into UCITS III funds by 2010. Positioned neatly between traditional and hedge fund strategies many long-only managers see this as an opportunity to tap into long/short-style returns without the attendant risks.
According to Merrill Lynch, 74 funds in the UK have adopted the incorporation powers associated with UCITS III status needed to run the 130/30 structures. What many long-only institutions have done, the report noted, is establish a parallel 130/30 fund alongside an existing fund. Sarasin Chiswell and Pictet & Cie Private Banking, for example, have both moved to offer 130/30 versions.
But while there has been a stampede to launch 130/30 funds, there has been little discussion about the optimal level needed to produce returns. Yet while 130/30 seems set to become the industry standard it is no means an indication that this particular strategy is accepted as offering the best alpha for investors.
"I find the 130/30 label unhelpful in many ways," says Nick Adams, head of institutional business at Henderson Global Investors. His point is that it implies a rigidity to the underlying investments that is simply not there. "It suggests it is a fixed rate or that it is a maximum or the optimal ratio. Yet none of those may be true for a given product," he argues. "The way that we approach it is from the client's perspective: looking at what level of risk do they want to run in a portfolio. From that level of risk with the implied or demonstrated information ratio you ought to get a given level of return."
Determining the investor's risk profile first will then allow the manager to design a strategy that will produce the optimal level of returns - not the other way around. "Once you have established the level of risk for a portfolio," Adams explains, "you can then work out the ratio of what longs and shorts you need."
Quite simply there is no optimal level - or ‘sweet spot' - that offers the best returns: every strategy is dependent on a number of external factors. "I honestly don't believe there is an optimal level," agrees Margaret Stumpp, chief investment officer at Quantitative Management Associates in New Jersey, "and I find it somewhat ironic that 130/30 has taken off as the Holy Grail. In all the work that we have done in various cap ranges and style categories the exposure that one ends up with is going to be very much dependent on several factors, but the most important is the level of tracking error at which one runs to run the strategy."
It is this route, Stumpp argues, that will then allow the manager to determine which level of exposure suits best. "We ask our clients for their level of tracking error and, depending on the capitalisation range and the benchmark, we will give you the average exposure level. For instance, if you look at our work in the large-cap core space," she continues, "if you had said you wanted no more than 3% tracking error over the full history your average exposure would have in fact only been 118/18."
For pension fund managers used to running enhanced index strategies with low tracking errors in the 1-2% range, the manager is not going to be able to devise a long/short strategy up to 130/30 that adequately matches its risk profile. A product with both a lower level of exposure to the downside of the market would in this sense be more appropriate: further adding fuel to manager sceptisism that there is an optimal level that suits all investors.
As the risk appetite increases so the investor will be able to gain greater exposure to the markets. Quantitative, for example, runs two funds targeted at 130/30 with a 4% tracking error, and a small cap fund at 150/50 with a higher tracking error of 6%. "The opportunity to add value is far greater in small caps," explained Stumpp, "and we wanted to take advantage of that which is why we're managing to 150/50."
Henderson, for example, has a 110/10 fund that was set up for an individual segregated client. "This was an enhanced index client who came to us a few years ago," explainsAdams, "and because they liked the excess return we were delivering they wanted to combine their enhanced index portfolio with pure alpha form of that investment process - or in other words a hedge fund built from the same process. The client now has an enhanced index portfolio combined with a small allocation to our market-neutral hedge funds. The net effect of that is a portfolio that is roughly 110/10."
Yet for others the difference between running a 150/50 and 110/10 is merely mechanical. "It is the same," argues John Forelli, a portfolio manager at Independence Investments in Boston, "but the difference comes from the amount of leverage that your client is comfortable with. If our client asks us to tell them what would be the best level for them we would argue that 130/30 is the level we think is optimal."
Independence runs two 130/30 funds, one mid-cap value and the other large-cap value. "We are also considering - and liquidity is an issue - a small-cap 130/30 fund. We feel we can offer these types of funds in any asset class that you want within the US equity markets."
Yet if there were further demand for more esoteric formulations, Forelli admits he - like any other fund manager - would look to incorporate this within new structures. "We would just look at it as a financial extension of our product," he says. "We do not look at ourselves as being just a 130/30 manager. If we had a prospective client that was interested in a 120/20 product we would just tailor our portfolio to their needs. There is a wide debate," he concedes. "You can do 120/20 - but it appears that 130/30 is becoming the sweet spot of what is becoming accepted in the US and from the research that we have done we believe that it is the best trade off in terms of getting the maximum return - the best information ratio out of a portfolio."
There has been a certain herd mentality determining the launch and increased demand for 130/30 funds. Forelli, for example is quite candid about the reasons for Independence's move into 130/30 funds rather than any other particular combinations: "We focus on 130/30 primarily because it has been accepted in the marketplace and we are comfortable with that level of leverage in the portfolio.
"To some degree there is a level of marketing spin on this. 130/30 doesn't sound too leveraged to people. If you start to say 200/100 then people are starting to look at a market-neutral strategy and that sounds a lot riskier than 130/30."
Indeed, this type of formulation has led many to argue that 130/30 funds are merely market-neutral-lite and that at times it seems as if investors are rushing into what they believe is the flavour of the month without truly understanding what they've bought. "The palatability of the ratio is certainly a factor," agrees Henderson's Smith.
"I am not exactly sure who initiated 130/30 funds," adds Stumpp, "but it has become like calling facial tissues Kleenex - it's all of a sudden become the norm."
But at what expense? "It has taken on a life of its own without any support, in my opinion," says Stumpp, "for that level of exposure because again the exposure is going to be driven by a number of factors, including the benchmark, the country of origin, the style category and the tracking error - all that needs to be taken into consideration when you are building the strategy."
So are investors - and if Merrill Lynch's report is correct then many pension funds are among them - rushing to invest in a strategy about which they have little idea? "Is the ratio itself actually relevant?" asks Adams "Or should we just see this as another form of high-alpha active management for investors to consider? Then it comes back to whether the investor is sophisticated enough to understand the use of short positions and the use of leverage within these portfolios."
Those institutional investors most used to hedge funds are the likely candidates to be knocking on the doors of companies such as Henderson or Independence, Adams continues. "They have been through the due diligence and understanding of what short positions are, leverage and the risks and are therefore comfortable with 130/30 stock strategies. Those institutional investors who haven't gone down the hedge fund route may take some time to understand."
More pertinently, given the extreme market volatility seen in August, will investors be more wary of taking out more esoteric products - or perhaps more likely - will they now see the upside of being able to make money out of the downside?
"The majority of plan sponsors that are dipping their toe into 130/30 funds are doing so with some trepidation," notes Stumpp. "They still haven't fully embraced the idea of shorting. They most likely have not adopted a market-neutral strategy and this is their first foray into the unknown - having to work with a prime brokerage firm, having a portion of your assets custodied away from you and, my goodness, actually borrowing stock and selling it short. Obviously the potential loss involved is infinite because the stock can continue to rise to the moon."
Given the potential losses - and the recent proof that markets do not always go up in a straight line - should pension funds be going anywhere near these strategies? Stumpp thinks they should, but with no expectation of any ‘sweet spots'.
"This investment topic has got more attention than anything I can recall in my 26 years in this business," she says. "However, August has shown these vehicles are not a panacea: they are products that have underperformance from time to time like any other strategy. Just because you have the ability to short and to neutralise some of the factors in your portfolio does not mean you have basically created a floor for performance relative to your index. You still have to go through periods of time when the factors that you use to determine your stock selection criteria will not work.
"What you hope is that these strategies protect you on the downside just a little bit, with smaller drawdowns and have shorter periods of underperformance. In the short term, August's volatility is going to raise awareness of some of these issues and may actually damp down some of the enthusiasm and slow down some of the migration from long-only into 130/30 funds."