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More Funds Turning to 130/30 Stratgies

Competition, if nothing else, keeps companies constantly looking for the next innovative product or strategy that will bring more assets to their firm. That is why many asset management firms are choosing to offer the increasingly popular 130/30 strategies as the benefits of shorting stocks can outweigh the benefits of going long, according to the report "130/30: From Rationale to Implementation" by New York-based Merrill Lynch.

"One reason for the growth of 130/30 strategies is the sophisticated framework allows for flexibility, and investors realize that it is difficult for a manager to extract all value from their fundamental views without having a flexible framework," said Benjamin Bowler, equity linked analyst and co-author of the report.

130/30, also known as a short extension, entails investing 130% of assets in long equity positions and 30% of assets short. Variations can be made depending on risk appetite. The strategy is kept balanced, though, as managers do not want to over invest.

For the report, Merrill performed several different case studies using quantitative analyses to analyze the benefits of long-only funds converted to 130/30 funds.

In general, the strategy is becoming popular because managers are able to explain their positive and negative opinions against a benchmark, said Ric Thomas, senior managing director and department head of the North American enhanced equity group at State Street Global Advisors in Boston.

The strategy is viewed by some in the industry as an extension of the next generation of asset management, Bowler said. "It is becoming increasingly competitive to find alpha and beta, and it's difficult to compete without all tools at your disposable," he said.

"There is nearly universal benefit from short-extending both in terms of alpha gains, as well as increased risk-adjusted returns," the report states.

Allowing a long-only manager to short sell provides much greater freedom to express negative views on a stock held in their benchmark, the report states. Managers are able to maintain benchmark characteristics, but tilt the strategy toward their stock model, Thomas explained.

The strategy allows managers to take better advantage of their skills, and if they are good, Thomas said, it will definitely help them to stand out.

Another reason that firms are implementing the strategy is the fee structure, Bowler explained. The fees tend to be higher than those for a fund using a traditional long-only strategy. And the more advanced a 130/30 fund is, the higher the fees, he said.

The fees charged on new 130/30 funds should be consistent to some extent with existing products. Existing short extension products charge annual management fees in the range of 60 to 90 basis points in the U.S.

A short-extension strategy will likely utilize some of the same skills, investment ideas and alpha already being offered by existing products, the report states. However, the report identified four major challenges that relate to starting 130/30funds.

One challenge is picking and managing the short side of the strategy. Shorting can be very complex and may present new challenges for many long-only managers, Bowler said.

Managers of quantitative funds may be more used to dealing with this, he said. However, fundamental managers can equally benefit from the added flexibility the 130/30 framework offers, Bowler added. The primary benefits of short-extending are fairly clear almost regardless of manager style, he said.

The strategy tends to work best for managers who have opinions on many stocks, Thomas said. Quantitative managers rank stocks every day, which is why they are able to handle 130/30 strategies well, he said.

He noted that the strategy is being viewed by some in the industry as possibly the new core for quant managers. There is less competition, to some extent, in the shorting area, as there are a lot more managers looking at long positions, Bowler said. Additionally, shorting positions is not something all managers are used to, Bowler said.

Thomas agreed that long-only managers need to be educated and walked through the process of shorting.

"The skills, information and implementation required for shorting stocks, or broader risks such as sectors or countries, are very different than those associated with the long-only investment paradigm," Merrill states.

Other challenges the report identified include implementing the strategy, constructing the portfolio and managing its risk, and marketing and distributing the final product.

By some estimates, there is between $30 billion and $65 billion invested in 130/30 funds currently. Many firms are starting to debut these types of products and more will likely do so in the future. The funds are able to be launched in as little as six months with less experienced firms taking up to 18 months, the report stated.

"Asset managers will continue to adopt a more flexible framework, whether it's using 130/30 strategies or derivatives," Bowler said. Portfolio managers are "becoming more sophisticated in the way they manage assets. The more sophisticated players who have good fundamental views ultimately will be able to deliver the most value for their investors," he said.

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