130/30 Strategies Set to Gain Traction: Interest From Hedge Funds on the Rise, But Jury Still Out on Actual Results
February 25, 2008
Hedge funds are increasingly trying to attract assets from institutional investors, and in their quest to do so more funds are implementing 130/30 strategies, traditionally a long-only product, according to Investment Dealers' Digest, IMW's sister publication.
130/30, also known as a short extension, involves investing 130% of assets in long equity positions and 30% of assets short. Variations can be made depending on risk appetite. For example, if desired a manager could launch a 120/20 strategy, which goes 120% long and 20% short.
"Everyone wants institutional assets," said Ben Phillips, managing director and head of strategic analysis at Jefferies Putnam Lovell.
Implementing a 130/30 product allows a hedge fund to make business more scaleable, he added.
"It's a more vanilla version of the exotic strategies hedge funds often implement," he said.
The current size of the U.S. 130/30 market is estimated to be $50 billion. Some estimates have 130/30 flows reaching $1 trillion globally over the next few years, and it's likely that many more hedge funds will start to test the 130/30 waters.
Quantitative and fundamental managers are implementing the strategy, and it provides a more flexible framework in which to work. 130/30 eliminates the long-only constraint and allows the manger to short 30% of the portfolio on which he or she has a negative view. The earnings from the initial short sale are used to purchase an additional 30%, bringing the total long exposure to 130% - 100% original long, plus 30% added. For the most part, the strategy uses large-cap equities in the portfolio.
However, the 130/30 idea can be implemented in many different ways, said Adam Berger, VP and head of portfolio solutions at AQR Capital Management, a hedge fund and long-only manager. Over time, he said, the concept will extend to the broader equity market to include small-cap equities, among others.
Institutional investors are interested in the products, and the strategy is growing in popularity. The most compelling aspect of 130/30 is the potential to increase alpha, said John Haugh, a pension fund and endowment analyst at Merrill Lynch. The strategy delivers an almost universal benefit in terms of alpha gain and increased risk-adjusted returns, and has increased levels of tracking risk compared with non-extended portfolios.
Merrill's January report on institutional demand for 130/30 products, which surveyed 160 institutional investors with assets of $1.5 trillion, found that 16% were invested in a 130/30 product. Public pension plans were the largest investors with 21%, followed by 19% from endowments, 11% from corporate pension plan sponsors, and 11% from private foundations.
Nearly one-third of institutions said they were planning to initiate or increase their allocation to 130/30 products over the next 36 months. Seventy percent said they would do so using a long-only manager while 20% plan to invest through a hedge fund manager.
Institutions may feel more comfortable with long-only managers as they have built relationships with them over time, said Haugh, co-author of the report.
Merrill also found that the majority of 130/30 assets are invested in quantitative large-cap U.S. equity, followed by fundamental approach. Quantitative managers back tested models and presented a better case to investors, whereas fundamental managers don't have that luxury. Now, as more fundamental managers receive seed money and employ the strategy they are establishing a track record, and garnering interest, Haugh noted.
However, finding realistic shorting candidates is better achieved with a fundamental versus quantitative approach, believes Giles Conway-Gordon, co-managing partner at Cogo Wolf Asset Management. Quantitative strategies, as revealed last summer, can be incredibly correlated, he said. Hedge funds took a hard hit in August due to volatility in the market and subprime losses and many quantitative equity strategies suffered losses.
Executing on those short sales is one of the major challenges to the strategy. Institutional investors have traditionally looked to their long-only managers for 130/30 strategies, but long-only managers are not used to shorting stocks, and may not be particularly good at it.
"Shorting is a rare talent to begin with, and it's hard to consistently profit on the short side," said Chris Wolf, managing partner at San Francisco-based funds-of-funds Cogo Wolf.
Institutional investors have started to inquire about 130/30 strategies that hedge funds offer because hedge fund managers are more successful at shorting stocks. Experts believe hedge funds are able to generate more alpha and absolute returns, as well.
Not everyone is sold on the 130/30 concept, however, mostly because it hasn't been tested in the marketplace for long.
"The strategy, which is new, largely rests its credibility on back-testing scenarios and ends up being another form of statistical arbitrage," said Conway-Gordon.
Quantitative funds started using the strategy, and simply took the bottom 10% of their quant screenings and shorted them.
"The net effect is that institutions relying on this strategy to be a safe step towards achieving hedge fund-type returns are likely to be disappointed."
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