Breaking the shackles of long only

In December last year, CalPERS, the largest public pension fund in the US, gave its seal of approval to one of the hottest current trends in fund management by appointing five global equity managers to generate investment returns by relaxing the long-only constraint in their portfolios. Without any accepted terminology for them, such strategies are popularly referred to as 130/30 strategies or sometimes 120/20 and describe an approach of shorting anywhere from 10% to 50% of the portfolio and reinvesting the same amount to generate a net 100% long only exposure to the market.

Merrill Lynch in a report issued in March said that a wave of asset managers would begin offering such portfolios this year as the gap between traditional managers and hedge funds continues to narrow.

While the evolution is a positive step, it does bring with it some potential risks, particularly for firms that do not already have strong risk control mechanisms in place.

It is not surprising that it is the quant firms that are leading the charge, and are likely to retain a dominant share of the market for such products.

By blurring the distinction between hedge funds and long only products, the increasing acceptance of 130/30 products may also put downward pressure on the fees chargeable by all but the most oversubscribed hedge funds.

130/30 funds are distinct from hedge funds with market neutral strategies that can have a low or even zero net exposure to the market. Many long only managers see such approaches as a natural and risk controlled extension of their current activities, and more significantly for them and for hedge funds, 130/30 funds are typically classed as traditional equity mandates by pension funds and not lumped into the much smaller allocations for alternatives that hedge funds find themselves competing for.

It is no wonder that hedge funds themselves are now in some cases, offering 130/30 funds in an attempt to be able to market their skills to a much wider investor base. Such convergence of approaches will also of course, give rise to a convergence of fee structures, with 130/30 structures likely to command perhaps only slightly enhanced long only fees, rather than the much higher fees that the hedge fund industry has seen as its natural right to charge.

The implications of a wider acceptance of such strategies may therefore extend to questions as to the appropriate fees for fund managers who exercise skills in shorting stocks.This is particularly the case if institutional investors find they are able to gain access to such expertise through the 130/30 route in a far more cost effective and, arguably, risk-controlled manner than through the traditional hedge fund route.

We live in a world where single digit equity returns are generally acknowledged to be likely for the global equity markets as a whole for some time to come. Moreover, not only is the volatility of equity markets much lower than it has been in the past, the dispersion of returns between better performing and poorer performing stocks is also seen to be reduced.

These two trends are extremely significant for fund managers and investors. First, to achieve double digit returns means finding managers who are able to add returns above the market - alpha.

Second, to take an extreme case, if all stocks produced the same return, there would clearly be no potential for any manager to produce alpha by selecting outperforming stocks. One may conclude that moving to a world of narrower return dispersions reduces the scope for any manager to outperform and it becomes more difficult to find any managers able to consistently produce alpha.

Perhaps a corollary of these two trends has been an increasing emphasis on the separation of beta and alpha with managers increasingly forced to develop more specialist products that can justify higher fees and demonstrate more clearly the alpha potential they have, if indeed they do.

As a result, as Merrill Lynch argues, "the mainstream fund management industry is being squeezed between the alternative industry and index funds". Nevertheless it adds: "To be fair, at just over two thirds of total revenues, the mainstream industry can claim that this squeeze is pretty benign."

The more opportunities a fund manager has in any given mandate to exercise his judgment, the more scope there is to outperform the market. In a long only mandate, clearly, the inability to go short means that managers are heavily constrained in the way they can exercise negative views on companies within the benchmark universe.

In extreme cases, a manager can only have a zero weighting to a given stock. This leads to asymmetries in the way that manager can leverage their research efforts.

If we take the S&P 500 as an example, the active bets that can be taken are very limited for most stocks in the benchmark. A typical risk constraint is that the active bet that can be taken should be no more than plus or minus 1% of the index weight.

However, as in most major capitalisation weighted indices, the S&P 500 is top heavy, with only 15 stocks having a greater than 1% weighting while over 250 stocks have a less than 0.1% weighting in the index yet make up over half the number of stocks in the index.

Excluding any of these stocks from a portfolio will have a negligible impact relative to the index performance. Scott Burrill and Joe Gawronski from Rosenblatt Securities point out in a recent note: "Removing the long-only constraint allows for overweight and underweight positions to be more evenly spread among the larger and smaller cap stocks in an index.

"This allows for a manager to more symmetrically express their views on stocks - both positive and negative - unconstrained by a particular stock's capitalisation, and ultimately the potential for greater alpha capture. All other constraints such as beta, sector exposure, individual stock exposure, capitalisation ranges and turnover may remain unchanged and identical to the long-only profile. The only meaningful difference is that the stock overweight and underweights are now symmetrical and independent of benchmark weights."

 

130/30 type portfolio works by starting with, say, $100m of cash to invest and a buy list of $130m of shares and a sell list of $30m. The fund manager would need to typically open a margin account with a prime broker who would facilitate the borrowing of shares to be short sold, clear the trades and have custody of the assets.

Typically, the short positions would need to be established before the long positions, to ensure there are no complications arising from a failure to find a suitable lender of each stock to enable the short sale to take place. This is important since many regulators impose expensive remedies or fines for failing to deliver the required share on the settlement date and some countries even forbid short selling to take place.

The total long position can then be established with both the $100m of cash as well as the proceeds of selling the $30m of borrowed shares. The short seller has to pay the lender a fee for borrowing the stock and, in addition, has to pay out any dividends that are paid on the borrowed stock. The fee for borrowing shares depends on how easy or hard it is to find a lender. Easy names are in the range of 25-40 basis points whereas hard-to-borrow names can be many times higher. Incorporating short positions into a portfolio therefore does require a detailed understanding of the actual costs for each separate stock.

The net result of this exercise is that the portfolio has a 100% exposure to overall market movements, whether up or down, but has 160% exposure to specific stock bets - 130% long and 30% short. The opportunity set for the manager has been increased dramatically to 160% of the long only set of opportunities, but as Burrill and Gawronski wryly comment: "This clearly is a double-edged sword as a skilled manager's opportunity set is a less-skilled manager's risk". While managers will often refer to risk around a benchmark being more symmetrical in such strategies, what is perhaps less often acknowledged is that absolute risk is dramatically changed. In a long only portfolio it is theoretically possible, although rare in practice, to lose 100% of your investment if all the shares went bankrupt. In a 130/30 portfolio, if the $30m initial value of the shorted stock portfolio was so badly chosen that it increased rather than decreased to more than $130m, the hapless investor would find that not only has he lost all his initial investment, he would be liable for any excess beyond his initial investment required to purchase the shorted shares to deliver back to the lender. As Andrew Alford of Goldman Sachs Asset Management (GSAM) points out in a recent note: "The potential loss on a short position is unbounded. In particular, a stock may jump in price if it is the target of a short squeeze, in which excessive demand by short sellers attempting to cover their short positions (either to limit their losses or satisfy a recall) causes a temporary run-up in the stock's price - and permanent losses for short-sellers forced to cover their positions."

Given that for a manager who does possess skill, widening the opportunity set by allowing short sales should enhance the potential for excess returns.

The question that then arises is to what extent should this be allowed? The answer tends to reflect a mix of academic theory, political constraints and pragmatic business strategy by fund management firms. Fund managers are often judged by the information ratio, the excess return divided by the tracking error of a portfolio. If this were of most concern, then the ideal policy would be to remove the no-short selling constraint entirely.

The theoretical opportunities for a $100m investment portfolio would then rapidly move into hedge fund products, which could range from completely market neutral strategies, with $100m in short positions, matched by another $100m in long with the $100m earning interest in cash, to leverage variations that may have a net long or even a net short exposure.

However, hedge funds are classed as alternative assets and generally have much smaller allocations within typical corporate and public pension funds.

 

If they truly can increase their outperformance through incorporating short selling, then rather than competing for the small slice of any pension plan that is allocated to alternative investments, long-only fund managers have hitherto arguably adopted a stealth approach of taking on some of the attributes of long-short hedge funds, sticking rigidly to a 30% short selling limit that enables them to retain their long-only status.

In practice, studies also show that as the benefits to the information ratio of shorting declines, the amount goes up. So the benefits of going from long only to 120/20 are greater than the benefits of going from 120/20 to 140/40.

As GSAM's Alford explains, "the choice facing portfolio managers and their clients is to select a level of shorting that is large enough to provide a significant improvement in expected alpha - and is large enough to justify the additional complexity and costs of shorting - but is not so large that the strategy is treated as a hedge fund, ie as an alternative investment."

It requires as much attention to be given to researching poor stocks as in seeking exceptional stocks if a manager is to be able to take views on which stocks are in the worst 10% of a universe deemed suitable for shorting and which are in the best 10% and therefore worth investing in. It is not surprising that 130/30 strategies have been dominated by quant firms, with virtually all the recent CalPERs long/short mandates awarded to such managers.

Many traditional fund managers pride themselves on their intense research processes that are geared to determining the outstanding companies worth investing in, and would readily admit to having no ability whatsoever to be able to select stocks worth shorting.

Moreover, managers with low turnovers and long investment holding periods, often find the very idea of determining stocks to be shorted introduces a short term "trading" distraction to what may be deemed as a long-term investment process. Pure quantitative fund management processes by contrast, can apply equal rigour to the compete universe of stocks, and rank them all in terms of attractiveness.

While the degree of confidence in any specific stock bet may be lower than a highly focused qualitative approach, it is no problem to have a large number of stocks that may number 200 or more in a portfolio on the long side, and 50 or more on the short.

While 130/30 approaches have been gaining increasing popularity in the US, they are also gaining traction in Europe. State Street Global Advisors, for example, launched its Global Alpha Edge product in March. With 350 positions selected from a universe of 2,000 or so international stocks, the product is based a quantitative screening approach based on a multi-factor financial analysis.

Ultimately, 130/30 products are just repackagings of existing long only capabilities combined with long/short hedge funds; quant managers in particular, are as well equipped to do a complete long/short fund as a 130/30 approach.

There will be cases where traditional managers may feel able to extend their performance capabilities by allowing themselves an element of shorting, although this may well be a step into the unknown for the manager, and pension schemes may not wish to fund such learning experiences at their expense.

The market for 130/30 products is therefore still on a steep learning curve. There is even no real consensus on appropriate fee levels, for example. Merrill Lynch has the sense that "fundamental 130/30 strategies will slot somewhere between long only and hedge, while the quant offerings sit somewhere between active index and long only".

For a management-fee only product this might represent an increase in pricing of perhaps one-and-a-half times the long-only strategy.

What is clear as Merrill Lynch point out, is that some firms have been offering such products for at least a couple of years, while others, such as Franklin and T Rowe Price, "do not generally short securities and so must grapple with the more fundamental question of shorting even as they consider the format of 130/30, so they are doing both".

Perhaps institutional investors may find that it is the retail investor who stands to benefit most from the wider use of 130/30 funds, since they give access to expertise in shorting stocks that institutional investors have always had through hedge funds but which retail investors have not.

The flip side of this of course, is that it may well be the retail investors who end up paying for the learning experiences of fund managers desperate to jump onto the gravy train of short selling strategies.