The long and the short of it

Big investors are expected in five years’ time to be holding $1,000bn in so-called 130/30 funds, a type of modified long/short fund that is emerging as one of the most successful new investment products.

The product is being sold by investment banks, asset management groups and hedge funds, putting it at the centre of the convergence between traditional asset management and hedge funds. It also reflects the increasing use of shorting as an investment tool.

The strategy now manages more than $80bn, with the amount having almost doubled in the past six months, according to research compiled by Merrill Lynch.

In the US about 80 fund managers in the past two years have either launched a 130/30 fund, or indicated that they plan to.

Bob Jones, the head of quantitative strategies at Goldman Sachs, says: “Everybody’s doing it, and if you’re not doing it, you’re an exception”.

Goldman launched several such funds last year and now has $4bn under management. State Street Global Advisors, the world’s largest institutional manager, has reached $10bn under management in the strategy.

Fidelity has launched a 130/30 fund for institutional clients, using a fundamental rather than quantitative strategy, with managers making their own stock selection.

The funds, which are mostly quantitatively managed, are being tested by the credit meltdown that has badly affected many quantitative strategies. Most were launched in the past year and have short track records.

Quantitative strategies suit 130/30 funds because the “quant” method is often to list stocks from most desirable to least desirable. The fund can take the least desirable ones and short them.

Morningstar tracks 74 130/30 funds and reports that during August, very few outperformed traditional long-only funds. However, they typically did not lose as much as quantitative hedge funds, because of the limited leverage of 130/30 funds.

Charlie Shaffer, the head of 130/30 funds at Merrill Lynch, says that so far, over the longer term most had beaten their long-only equity equivalents.

The strategy, sometimes called “hedge fund lite”, typically invests 30 per cent in short positions, and has 30 per cent leveraged, making it attractive to pension funds or endowments keen to lift returns but wary of unfettered hedge funds. The fees are pitched between long-only equity and hedge fund fees.

Several mutual funds using the strategy have also been launched, though the majority of money in the strategy is from institutional investors.

Trying to improve on the clunky name, some firms have tried marketing them as an “edge strategy”, “flex strategy” or “short extension” funds.

The product gives hedge fund managers a chance to bid for traditional pension fund business without scaring them off.

Morgan Stanley recently issued a report on how long/short hedge funds could become 130/30 funds – and thus be reclassified as a “traditional” rather than an “alternative” asset class.

Pension funds classify 130/30 strategies as part of their mainstream equity portfolios for asset allocation purposes. That means there is potentially a bigger pot of money to go into the strategies.

Shaffer says: “We were
out there early to say this product could hit a trillion [dollars].”

He adds that Merrill expected “significant convergence between long-only equity and unconstrained investing styles”, and that once clients had become comfortable with the 130/30 product, they were asking for higher levels of shorting and leveraging, such as 170/70.

Steve Deutsch at Morningstar says 130/30 funds are fairly conservative investments. “They will end up with returns not as high-flying as the general market, but they won’t reach the lows either,” because of their shorting component, he says.

Most funds offer 30 per cent shorting and 30 per cent leveraging because those are the optimal levels that have shown to increase returns without significantly increasing the risk.

However, as Shaffer says, once investors become comfortable with the idea, it seems likely they might want to opt for higher levels of leveraging.

This would increase the risk of the investment, which might seem to defeat the purpose, but if the investor was happy with the manager’s overall performance then a slightly higher risk/return level might be acceptable.

As more traditional mutual fund managers launch these products, there are also likely to be more fundamentally managed funds available.

There has been little research on whether fundamental or quantitative styles are better suited to 130/30 funds.

That is a question investors would need to answer, and might also depend on how quantitative managers respond to the downturn in their style.

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