What makes a good 130/30 manager and what are the products on offer? Most firms offering 130/30 products agree that the question is not one of fundamental versus quant because neither style is immune to underperformance. Jason Toussaint, senior vice-president and senior investment strategist in quantitative management at Northern Trust Global Investments in London, says there are a few basic requirements to ensure success in this field, “As a client you have to ask whether the manager has information insight into the markets it proposes to cover and if it can generate alpha.”

Northern Trust has its own proprietary quantitative model, fed with information by a global research team. Toussaint says the researchers identify alpha, which they already do on the long-only side. Northern Trust also uses optimisation and risk modelling tools to construct its portfolios.

“The markets continue to evolve, therefore we assume ‘we are missing something’ to improve our process and adapt to fundamental changes,” says Toussaint.

“It is generally not such a great leap of faith by existing long-only clients that you already have built a good relationship with to invest in these products because they are still constrained.”

Northern Trust has maximum over and underweight limits on a per-constituent basis in its 130/30 funds. “If the smallest security in the index allows us to express our maximum underweight position without shorting, then there is no need to short. We don’t short for the sake of shorting, rather we short to enable us to fully express our negative views in the portfolio” Toussaint says.

He says that it is very different to be underweight in a stock than to say that it will go down in value. “We are saying it will underperform the index, not necessarily go down in value.”

He argues that, as a quant manager, the firm identifies all factors on each stock, therefore it is not difficult to short stocks. However, fundamental managers also use quant techniques that may assist in shorting.

It has been argued that 130/30 funds are faddish - just another marketing innovation that benefits the service providers, with clients’ interests as a byproduct. In particular, some argue that this is the case because hedge funds are also getting in on the action with launches from Zweig, DE Shaw and Renaissance Technologies, among others.

“An interesting thing to look at is how these funds did in August as the market-neutral funds were badly hit, particularly mid-month,” says a fund of hedge fund analyst working for a family office. “People need to be aware of the model risk they are taking. As lots of assets are managed with the same underlying process and model, there is likely to be a huge overlap in the assets held. If one fund has to sell a large number of positions, or the market doesn’t conform to the history built into the models, both of which happened in August, there may be the possibility of substantial underperformance versus the market for these vehicles.”

The suggestion that 130/30 funds are ‘hedge funds lite’ or substitutes for absolute return funds is rejected by most. It is argued that the initial confusion was because of the shorting element in the portfolios but that potential clients now understand the differences.

Lorin Gresser, head of alternative investments and product development at Threadneedle, says companies with shorting experience stand to gain from the 130/30 development. “Experience of shorting is key because it is a different time frame and a different approach to long-only management.”

Gresser says Threadneedle has the optimal combination of hedge fund and long-only experience to be successful as a 130/30 manager in Europe. She says clients understand that the objectives of 130/30 funds and hedge funds are different despite using similar techniques.

Divyesh Hindocha, global director of consulting at Mercer in London, says 130/30 is a genuine and welcome innovation that his firm will promote to clients. He says that the active extension approach of 130/30 funds is attractive because it includes the shorting element, akin to hedge funds, but offers better transparency and operates in confined and specified regions.

“From the experience we have from Australia, where 130/30 funds have been available for some time, it adds value as it increases the information ratio.” Hindocha notes that there could also be a loss of value as managers need consistent stock-picking skills on both the long and the short side.

He adds that manager selection will be more challenging because of the skill sets required. And costs should not be underestimated. “Financing could also become an issue in the coming months, because of the liquidity shortage in the context of what happened in August,” he says.

This does not seem to worry everyone, as a flurry of launches of 130/30 products are on the cards. Northern Trust has 130/30 products for US equities benchmarked against the Russell 1000, with over $6bn in enhanced indexing strategies, of which the 130/30 funds are part. The firm is planning launches next year for MSCI World and MSCI EAFE products. Subject to change and an application to the Financial Services Authority for approval, Threadneedle plans to launch in the UK a 130/30-type fund focused on US equities during the fourth quarter. It already manages some $2.5bn in hedge fund assets. “We expect the new fund to be managed by Stephen Moore, a US equity fund manager who joined Threadneedle in 2002. Plans to launch the new fund in Continental Europe will follow,” a spokeswoman says.

Barclays Global Investors launched partial shorting equity funds in 2006 and now manages $6bn of developed equities across the US, Europe, Asia and Japan.

Nicolaas Marais, head of European active equities at BGI, says its approach is a scientific mindset without being a black box. “It comes down to the ability to look at winners and losers in the same consistent and symmetrical approach. As a client you also need proof of added value as well as track record and experience.” He adds that if you are not good at identifying winners the lack of skill will be magnified in a 130/30.

BGI wants to offer clients a broad menu of choices, “As markets change and investors grow in sophistication and experience they will look at managing risk in more sensible ways.” Paul Quinsee, chief investment officer of core US equities at JP Morgan Asset Management in New York, says a successful manager will need insight into which stocks to short and not have to re-invent its investment process. “It is also a question of managing the underlying additional risk in portfolio construction as well as understanding what operational experience you have, such as what prime brokers do and how to manage those relationships.”

Quinsee says that JP Morgan has a fundamental approach but has three years of experience in 130/30 for US equity clients, with assets of $2.7bn. JP Morgan’s research team uses a rating system, looking at both top and bottom performing stocks, giving an insight into shorting. Operationally, JP Morgan has been managing short selling for 15 years in New York and in Europe 130/30 funds will be part of its behavioural finance process.

Only time will tell if this is indeed an innovation that has come to stay and whether 130/30 will lead pension funds down a new road to success or just up the garden path?

The nay-sayer

One company that has no intention of launching a 130/30 product is T Rowe Price. Todd Ruppert, president and chief executive officer at T Rowe Price Global Investment Services, says the firm is a fundamental bottom-up stock-picking house and has never shorted stocks. “Our analysts spend their time looking at stocks that are going up, not at those that don’t work.”

He says that there will be some success stories within 130/30 but adds that satisfaction is reality minus expectation and that an innovation by nature is not necessarily successful. “There isn’t any proof that because the long side works the short side will too. It is not in the DNA of our analysts to short stocks.”

Ruppert says that when T Rowe decides to launch a product it will ask if the firm will be very good at it. He argues that the majority of long-only managers underperform the benchmark, so combining two ways of picking stocks when you cannot get one right does not bode well. “We stick to what we know and existing clients come first. A prospect is not a client. We manage over $200bn in long-only assets so it would not be fair to the existing clients to ask the analysts to take their eyes off the ball to find shorting opportunities.”

Topics