130/30 Funds: More Than Hedge Fund "Lite"?

Stuart Fieldhouse

17 September 2007

The craze for 130/30 funds seems to be taking the institutional investment market by storm on both sides of the Atlantic. The success enjoyed by the likes of State Street Global Advisors and Barclays Global Investors in this field seems to be encouraging many more fund management houses to plot their own entries to the market. According to Merrill Lynch, which published a report on the subject earlier this year, “We are expecting a wave of asset managers to begin offering "130/30" portfolios this year, as the gap between traditional managers and hedge funds continues to narrow.” The classic 130/30 fund portfolio combines a 100 per cent long-only component with a 30 per cent long/short portfolio, in effect creating a high conviction long portfolio, although slightly differing approaches are possible (see below). It is not a hedge fund; rather, it is a long-only fund which can make use of some hedge fund techniques to support the fund’s manager in his risk management efforts. “Simply put…by relaxing the constraint that managers can take very aggressive long positions but only underweight a position by its index weight, gives managers more freedom to manage,” Merrill Lynch said in its report. “Since the only reason for investing in an actively managed fund is that you believe the manager adds value compared to the index, this is an appealing concept in our view.” Part of the excitement for fund management groups, particularly those with existing ranges of hedge funds being run internally, is that institutional investors and private banks might be tempted to allocate to 130/30 strategies out of the long-only component of their portfolios. In other words, there is a good chance that these funds will be treated as mainstream investments, not hedge fund “lite” going forwards, and could potentially unlock millions of dollars in new investment. One of the market leaders, SSgA, has been demonstrably effective in winning considerable investment from institutional investors like pension funds. Kanesh Lakhani, a senior managing director with the firm in the UK, says investors are moving towards more of a global stance for their equity strategies, and at the same time are focusing on increasing the alpha produced by these portfolios, within an efficient risk-budgeting framework. He thinks SSgA’s range of “Edge” strategies, which draw on his firm’s strong background in quantitative investment management, will meet this kind of challenge. “These funds are a more efficient way of providing the high alpha which clients want,” says Rick Lacaille, chief investment officer for Europe at SSgA. “As markets become increasingly efficient, it makes it easier for fund managers to spot dramatically over-priced or under-priced stocks.” The Squeeze Effect The emergence of 130/30 strategies is part of a “squeeze” effect taking place within the long-only fund management industry. Investors are increasingly waking up to the fact that they can acquire more valuable active management in hedge funds, while index returns can be cheaply acquired via ETFs. Big long-only groups without a pet hedge fund unit are being asked how they can continue to add value via a long-only benchmarked approach. The birth of 130/30 funds may provide the answer, especially as they can also be pass-ported in the EU as UCITS III products. We have already seen a trend within the industry over the past three years for conventional fund management groups to launch and expand their own internal hedge fund offerings. This has partly been to help them retain top talent, and partly to satisfy a demand for long/short strategies from their client bases. Particularly successful in this respect are the likes of Gartmore, Henderson, and F&C. These are firms that have invested heavily in their quant desks as well, and are best-suited to offer 130/30 funds thanks to a familiarity with long/short investment strategies. But what of those groups tempted to launch 130/30 funds without existing hedge fund expertise? There is an obvious temptation to give a long-only manager the scope to manage a 130/30 product, but not every manager is suited to this. It would also require a substantial investment in risk management systems that would allow the firm to comfortably manage a short book, something many fund managers have not had to do as yet. It means investors will need to carefully scrutinise the pedigree of the firms and individual portfolio managers behind any new 130/30 launches to ensure that there is the depth of experience and infrastructure behind that offering to warrant buying it. “I’d be nervous of new firms venturing into this space,” says James Davies, the investment research manager at Chartwell, a large UK financial advisor. “I would need to see what sort of team they had running , I’d want to see their track record. On the short side the risk of loss is potentially unlimited, so we’d need to be comfortable that the manager knew what he was doing.” Part of the appeal of 130/30 funds will be their very predictability when compared with hedge funds: some consultants are already classing them as “beta 1” products. They like the fact that these funds are more likely to react along certain lines in given market scenarios, something which many hedge funds singly failed to achieve in recent market turbulence. And it is not simply 130/30 funds that will be launching over the next few months: Janus has already produced a 120/20 fund, for example, and there is talk of more highly leveraged vehicles like 140/40 or 300/200. Janus’ subsidiary INTECH was behind its 120/20 launch in February, what it describes as a collared long/short strategy. Again, it seems that it was investor demand for a strategy with a short book that was subject to a more demanding risk management policy that lay at the heart of the decision to launch the fund. Investors in the US who were concerned about allocating directly to hedge funds, were more amenable to a conservative approach to long/short investment. Over and above this is the issue of the type of market the fund is designed to invest in. The 130/30 approach may not be suitable for all situations. The early funds in this area chose this ratio as a result of the original R&D that had been carried out using the S&P 500 universe of stocks, but 110/10 is considered more appropriate for a Canada fund, for example, and a pan-European fund might require a 150/50 ratio. In addition, there is also the issue of how the portfolio is constructed. Some funds are using a 100 per cent long portfolio, with a 30/30 long/short sub-portfolio attached, but others are being run along pure 130/30 lines. It makes a big difference, some pundits argue. State Street, for example, is an exponent of running a uniform portfolio. “What you have on the short side will have a bearing on the long portfolio,” says Mr Lacaille. “All the components are linked, and it is important that they are. If you have found some high alpha stocks, you would still have to control the size of your exposure, and it wouldn’t be sensible to put them back in the 30/30.” It is increasingly obvious that 130/30 funds and their variants are attracting attention from investors. Whether they will also end up on the retail shelf remains an open question. The current market leaders do not consider their funds as suitable for retail distribution, but some other groups that are in the process of grooming their own versions for launch later this year – markets permitting – feel there could be take-up from third party fund distributors and wealth managers, and that there is a real demand in the private market for so-called high conviction investing.