The man in charge of a JP Morgan Asset Management-run portfolio, known as a 130/30 fund argues why this structure carries a lot of credibility in an uncertain market environment.

It seems like a lifetime ago but before the 2008 financial
crash the investment business was abuzz with a new, strange-sounding creature
called the “130/30” fund. But they haven’t all set the world alight.

One firm that seems to have lived up to the billing is JP
Morgan Asset Management. Nicholas Horne, who manages the JPM Europe Equity Plus
fund (Luxembourg SICAV), has plenty of reason to draw attention to the benefits
of these portfolios. It has handily beaten the MSCI Europe Index (Net) by more
than 30 per cent over three years and is first-decile ranked over the year to
date, six months, one year, three years and five years. It also has a five-star
rating from Morningstar, the research firm. It holds €398 million ($529
million) of client money.

The fund’s ability to take both long and short positions in
the stock market might superficially resemble a hedge fund, although Horne
argues that there remain significant differences. Even so, with European and
other equity markets so volatile in recent years, the ability to play both the
negative and positive aspects of a market has a lot of appeal. 

How it works

“The approach of a 130/30 fund allows investors with the
ability to identify potential under-performers as well as out-performers to
express their insights more fully. In a long-only portfolio it is difficult to
generate significant alpha from underweight positions because there are so many
stocks with small weightings in the benchmark and many more that are not in the
benchmark at all. Active extension funds allow you to better align the
positions in your portfolio with your views and create the potential to earn
higher returns for the same amount of risk,” Horne said in an interview with
this publication.

An investor puts in, say, €100 and gets 130 of net long
exposure by also shorting 30 per cent of the portfolio and using the proceeds earned
by those short positions to finance more long exposure. This is how the term 130/30
arises. (A fund could also be a 120/20 design or some other split but the
principle is the same.) These portfolios are also known as “extension funds”
due to the ability to extend a long position with the money – hopefully – owned
by shorting stocks.

The idea is that such a balance of exposures will give a
more stable set of returns in different market environments, a highly
attractive offering given the market gyrations of recent years, he said. “This
product should be considered as a mainstream equity fund,” he said.

So-called 130/30 funds were launched with a “lot of fanfare”
in 2007, Horne said. “Expectations were they would perform very strongly and
initially some didn’t,” he said.

That is certainly the case. A quick Google search on such
funds brings up headlines such as “The decline, fall and afterlife of 130/30” (Financial Times) and “Jury Is Still Out
on Value of Once-Hot 130/30 Funds” (WSJ.com).
Far more positively, though, a report last December by Lipper, the fund
tracking firm, said: “Despite these [market and other] constraints, 130/30
managers have outperformed buy-and-hold managers in the United States, in the EAFE countries, and in Australia. This
indicates that a benefit of the 130/30 approach is that an investor can add
value to their holdings by combining buy-and-hold investments with an actively
managed component.”

Horne said that 130/30 funds, possibly due to lack of
understanding of how they worked, came in for some tough criticism, perhaps
unfairly.

“It is worth pointing out that many investment strategies
underperformed in 2008 during the financial crisis. However, the market judged
active-extension funds more harshly than long-only funds because they were new
and didn’t have long track records,” Horne said.

Anomalies

The investment approach of this fund is inspired by the
insights of behavioural finance, Horne said. “There are consistent exploitable
anomalies in the market,” he said.

The approach involves a combined focus on three key criteria
in stock selection: attractive valuation, quality measures (as demonstrated by
earnings quality and operational quality) and momentum, he continued.

“We aim to exploit market inefficiencies driven by
investors’ behavioural biases by picking stocks with certain style
characteristics. For example, cheap stocks consistently outperform because
valuations are often based on what is fashionable rather than fundamentals and
because investors tend to be inherently overconfident about their conviction
(either too pessimistic or too optimistic). High quality stocks with good
earnings and capital discipline outperform because investors give insufficient
credit to profitability,” he said. “This approach is more attractive than just
buying the index,” he said.

The fund doesn’t take big macro calls. Instead, it looks at
stocks on a three to six-month basis and is a pretty dynamic strategy. It includes
a diversified portfolio of 150 to 300 holdings and both long and short
positions have contributed positively to performance through varying time periods.
Also, the fund has a low three-year tracking error and a high information ratio
(measure of the risk-adjusted return of a financial security).

Investment opinions

Horne reckons that the European equity market has been
unloved, in some ways unjustly. And that’s great news for a value investor.

“My view is that European equities are cheap on a cyclically
adjusted PE basis which is around 13 times. Other asset classes look
expensive,” he said. On a forward basis, European equities have a dividend
yield of around 4 per cent, he said.

“Europe is clearly not in a
strong situation but as an investor the European corporate sector is different
from the European government and personal sector. It has a lot of global
businesses.

“Earnings have been pretty flat in Europe
but there are early indications that the earnings cycle is starting to turn.
The policy backdrop remains broadly supportive,” he said.

“If anything we’ve actually been arguing European corporate
balance sheets are under-leveraged and not over-leveraged and that companies
should issue more debt cheaply. Of the top 500 companies in Europe,
1 in 3 has net capital on the balance sheet (no debt) and European companies
are forecast to generate $1 trillion in free cash flow next year. A lot of that
cash will be going back to shareholders in the form of dividends,” he said.

Based on virtually any valuation metric you want to use,
discount of European equities relative to US equities is approaching 20 per
cent and we’d say that discount is too aggressive,” he said.

“A key point for investors is not absolute growth rates
within Europe so much as investor
expectations. European economic growth is lacklustre yet the region’s
approximate 30 per cent out-performance has been driven by rate of change of
expectations. Europe was in a recession and
now is facing a period of little to no growth but still that constitutes an
improvement on the expectation of what would have been continued recession.
Hence, equity markets trade on changing expectations,” Horne added.