Funds Struggle with Complex Trading Strategies: Experts Caution Extra Care When Leveraging
February 25, 2008
MIAMI - Asset managers have been looking to complex trading strategies such as 130/30 funds to create additional alpha, but experts stress that investors should be careful to fully understand these products, and use them carefully.
130/30 funds use leverage to short sell poor-performing stocks - up to 30% of their value - and then re-invest the money into top-performing stocks.
"You are effectively selling shares you don't own in your portfolio by borrowing them," said Michael Rosenberg, director of prime finance for Citi, at the National Investment Company Service Association's conference here last week. This year's theme was "Cultivating Growth."
The idea behind 130/30s is the poor-performing stocks will continue to drop in value, and an investor can buy them back at a lower cost than they borrowed them, he said.
"If you have a specific stock index, you can borrow shares to secure a location for a desired short position, go to an executing broker to have them execute a short sale, and have them post the collateral as a margin for the short position," Rosenberg said.
Leveraging can provide easy profits, so long as it isn't being overdone and the trends continue to go the way the buyer hopes, but the strategy also comes with greater risk.
Past performance does not guarantee future results, and leverage magnifies both gains and losses.
Many managers are worried that complex trading strategies could backfire and spill over into other areas, like the fallout from sub-prime mortgages.
Tens of thousands of homeowners bought mortgages on homes they couldn't afford with the expectation that housing prices would keep going up. When the housing bubble burst, the homes lost value and homeowners owed more than they had.
"This trend is not going to stop," said David Lang, managing director of the asset management division of Goldman Sachs. "Some will get it right and will be very successful. Others will not."
Lang suggested managers set up a committee with formal guidelines and senior representation that has "teeth," or the authority to stop trading if they don't feel comfortable. They can also create a centralized database that inventories instruments, said the Goldman managing director.
Firms should also have a good legal team that works closely together with investment managers to negotiate, reconcile and capture transactions, Lang said.
"Contract terms are not standardized," said Don Gignac, senior managing director of alternative investment operations for International Fund Services. "There are significant ramifications if it's not done thoroughly."
Gignac advised firms to require careful review of contracts with their legal teams.
There are already some controls in place for mutual funds. The Investment Company Act of 1940 set limits on the service charges, financial disclosure, fiduciary duties and filings of mutual funds.
"40 Act funds are heavily regulated and have limits on leverage," Rosenberg said.
Products like 130/30 funds can provide a little kick to a well-balanced portfolio, but they can be dangerous if mismanaged, or if an investor is unlucky. Investors can reduce their overall risk by investing in a diverse range of stocks, bonds, mutual funds, exchange-traded funds and other alternative investments.
For those who can afford them, hedge funds allow "ultimate flexibility" and diversification, Gignac said.
Hedge funds employ short-selling techniques as well as the use of arbitrage, leverage and derivatives, but their big appeal to high-net-worth investors is their low correlation to other asset classes, he said.
Fund companies looking to engage in complex trading strategies need high-quality resources and robust middle- and back-office support, said Kevin O'Connell, a partner at PricewaterhouseCoopers.
Few people understand these complicated strategies, and knowledge is in high demand.
"There is significant competition for high-quality staff, particularly among hedge funds trying to steal talent," O'Connell said.
Hype, Fad or Trend?
Another investment strategy that has fund executives concerned is actively managed exchange-traded funds.
"I don't understand actively managed ETFs, and that bothers me," said Marianne Smythe, senior counsel of investment management for WilmerHale and a former director of the Division of Investment Management of the Securities and Exchange Commission.
"Mutual funds are traded throughout the day, and ETFs are traded throughout the day, yet they can have very different results," she said. "The idea makes me uncomfortable. The whole market-timing mess started with late trading and international markets."
John Brennan, chairman and CEO of Vanguard, said he considers ETFs to be another form of mutual fund.
"We should encourage investors to use ETFs as tools," Brennan said. "I think actively managed ETFs are here to stay. They won't replace actively managed mutual funds, but they will put pressure on mutual funds to be innovative. I think it will make us better through competition."
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