Fund managers no longer just care about generating straightforward equity returns and beating benchmarks – today it is all about adding so-called value.
Alternative assets and hedge funds fit the bill, as do absolute return funds, but so does another breed of fund – 130/30 – that began in Australia and is gaining prominence in the US.
So-called 130/30 funds have yet to make it big in the UK. The question is whether they ever will.
In essence 130/30 funds are part ‘long-only’ funds and part ‘short’ funds – the idea being that they can add value during times of market toughness. They rely on the other buzzwords circulating fund management circles – alpha and beta.
For many investors it is no longer enough for fund managers to simply produce funds that achieve beta by modestly outperforming an index – they seek investments that generate genuine outperformance, or in techno speak – alpha. UCITs III has given fund managers the green light to delve into 130/30 funds.
Jeremy Hall of Cartesian Capital Partners says: “Traditional long-only funds limit fund managers to take only positive stock views. Relaxing the long only constraint affords the manager more freedom to express negative views on a security. The manager can short an unattractive stock with the goal of buying it back in the future at a lower price, thereby potentially profiting from the transaction. At the same time the manager has the ability to invest an additional 30 per cent in his or her strongest long ideas.”
Stephanie Fennessey, client portfolio manager US equities, JPMorgan, echoes Hall’s sentiments. She says: “The aim is to generate higher returns out of your assets. Traditional long-only funds enjoyed decent returnsin the twenty years preceding the technology bubble in 2000. But even if we get a bull market the chances are the returns will not be as high. You need to add value and these strategies loosen the constraints of a manager.”
Despite being able to short, borrowing securities on the basis they will be bought back later by the broker, hopefully at a lower price, many advocates of 130/30 funds claim that they are only slightly higher risk than a bog standard blue chip equity fund. Their advocates strongly deny they are akin to hedge funds.
F&C argues that one of the biggest misconceptions is that enhanced alpha, long-short extension and “130:30” funds as this group are known, are some form of quasi hedge fund and therefore might form part of an “alternative” allocation in a pension. That might lead you to allocate very small amount to such strategies, well below 5 per cent, alongside hedge funds, private equity.
Jason Hollands, at F&C says: “Enhanced alpha funds are most definitely not halfway hedge funds. An enhanced alpha fund is simply a high octane equity or bond fund that should, theoretically, accentuate the benefits of good stock selection by providing access to a broader universe of positions and more efficiently utilise research and insights. This is because, self-evidently, half the companies in the market will underperform the average and half will overperform.”
A 130/30 fund invests 100 per cent of its money in equities – in many cases blue chip shares that roughly mirror a stock market index. But the manager sells or “shorts” 30 per cent of the portfolio and uses the proceeds to fund 30 per cent of purchases. This means that investors are still 100 per cent exposed to the market, as with a traditional “long-only” equity fund.
A short extension strategy gives a fund manager the option to sell short a stock that he believes will underperform and this gives them the opportunity to make money from stocks that go down in value. In addition, they also have the opportunity to increase their exposure to their ‘best idea’ high conviction stocks.
If share prices rise or fall, the fund is likely to roughly mirror these movements. But if the manager has made the right call on these individual “short-and-long” positions, investors will see some additional gains.
For example, if the manager is confident that BP shares will outperform Shell, he can “short” Shell and boost his holding in BP. If Shell falls in value and BP rises, the manager pockets a tidy profit. But the reverse can also happen, and the wrong call can magnify losses.
Todd Trubey, a fund analyst at Morningstar, says: “Given that it has 130 per cent positive exposure to the market and 30 per cent negative exposure to the market, the net result is 100 per cent exposure to the market. So before the manager’s stock picks are factored in, it should behave very much like a standard long-only fund.”
Hall adds: “With a 130/30 short extension strategy, the manager can short 30 per cent of his capital, which means they can leverage the long-only position by 30 per cent. The total leverage in terms of putting ideas to work would be 130 per cent on the long side and 30 per cent on the short to give 160 per cent. This is against a maximum of 100 per cent in a long-only approach.”
So far, 130/30 investing is most prevalent in the institutional world. According to the Investment Management Association, asset remains a ‘modest £6bn’ in the retail arena, with less than a fifth of its members showing any interest.
F&C, one of the few fund managers to enter the 130/30 world, reckons there is a potential place for these strategies within a retirement portfolio, providing one understands what they are trying to achieve and where they might fit in an allocation. It argues that fund managers who offer 130/30 funds are researching companies, so they will discover reasons to invest in them for gains, but conversely they will eek out reasons why they might underperform.
“Fund managers either ignore all those companies that they believe will underperform or they might go overweight/underweight larger stocks,” says Hollands. “Enhanced alpha funds enable them to use some of this information to generate extra capacity for backing their higher conviction stocks.”
It is point reiterated by JPMorgan. Fennessey says: “If you are analysing a company you get an insight as to whether you think the stock will rise, or whether it will fall – 130/30 gives you the advantage of using both sides of the coin. It is not a hedge fund as you still have 100 per cent long exposure – but you get more bang for your buck.”
She backs up her argument with JPM’s performance – since it launched the concept it has outperformed the S&P500 by 5.1 per cent per annum – its plain vanilla portfolios have outperformed to a lesser extent – 2.6 per cent per annum, she says.
But some experts point to the way that 130/30 funds can amplify negative returns when things go wrong. “With 130/30 funds, stock picking is even more important, as managers must correctly pick shares that will go down and shares that will go up. This creates the possibility that if the manager fares poorly on both fronts, the fund could suffer much more than he would at a long-only offering,” says Trubey. “In short, 130/30 funds sound good in theory, but they are extremely dependent on the stock-picking skill of the manager and carry potentially greater risks than long-only funds. Until we see clearer evidence that they can consistently add value over the latter, we don’t think there’s a compelling reason to include them in portfolios.”
The other stumbling block to 130/30 – as with any innovative fund – is getting the investors to understand the mechanics of the fund. The very fact that they do not have a long term track record is not helpful either. Although there a few funds in the UK, there are just over 60 in Europe, and performance has been sketchy to say the least. Of the 27 with a 12-month record, not one delivered a positive return and many have fallen by more than 20 per cent.
“I am not a fan,” says Daniel Peters senior investment consultant at Aon Consulting. “It is vital that employers and employees understand, but it would be difficult enough to explain 130/30 to trustees let alone those on the shop floor. I can’t see them developing in the DC and GPP space.”
Andrew Merricks, at Brighton-based Skerritt Consultants also questions whether they are suitable for a work place pensions. Sophisticated investors with Sipp portfolios might show an interest, but company pensions are a different matter altogether, he says.
“I can’t see that they fit into run-of-the-mill GPP or DC workplace pensions to be honest, as they need more monitoring than alternative funds. Unless the sponsoring scheme allows for regular member reviews with an IFA or pensions consultant who is able to advise on specialist funds, there is the danger that a member of a group scheme will be sitting in a 130/30 fund long after they should have moved on. They are not default funds.”
Hollands disagrees, arguing that an enhanced alpha fund should therefore be considered as a potential candidate for an equity weighting in a pension, not as an alternative weighting. That means they could in time deserve a fairly attractive slice of a pension portfolio, he says.
“However, you would probably only want to consider these as satellite funds within an equity allocation alongside more traditional benchmark-aware core funds, or index products,” he says. “In other words, over time these may be seen as displacing traditional aggressively managed equity products such as high alpha or focus funds, but they could certainly enjoy a bigger allocation than say a hedge fund product.”
But perhaps it is unfair to write the funds off just yet. When 130/30 funds emerged in the US in 2004 only large institutional pension funds showed an interest. That, according to JPMorgan is gradually beginning to change with education and familiarity, and DC schemes in the US are beginning to take note of their benefits.
It also adds that they are already part of DC and GPP portfolios in the UK already because several fund of fund managers are selecting them for multi manager portfolios for diversification.
“We strongly believe that over time the 130/30 concept will replace long-only funds. They are more flexible and are another tool to get higher returns,” says Fennessey.
Cynical press coverage will not help improve their popularity, but Fennessey admits that much of the mediocre coverage to date has been ‘warranted’ because performance form the sector as a whole as not been very good – particularly from 130/30 funds managed on a quantative basis.
She argues that to get the best results managers have to be qualitative, as that is the true way of delivering value. But Fennessey admits that it has its work cut out to make an immediate impression. “It is slow going,” she adds.
A long hard look at shorting stocks
Many financial advisers and pension consultants wonder whether there is sufficient talent to see 130/30 become mass market. Anthony Bolton, arguably the leading fund managers of his generation, questioned his own ability to short stocks which is why he steered clear of hedge funds. Indeed, the latest IMA survey raised the concern of fund managers having the requisite skill sets.
Great stock-pickers are hard to find – you only have to look at the performance figures to see that all too often, active managers of long-only funds trail their benchmarks. Resolution Asset Management, which has just published a guide to advisers on 130/30, admits that the risks posed to their success include that ‘stocks to short is a specialism requiring different skills from picking long stocks and that running a short extension fund requires skills many managers have yet to develop’.