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PENSIONS - The Long and Short of 130/30
Can short-extension funds stay in fashion after this summer’s market turmoil?
The hottest new product in institutional money management in decades just got a whole lot cooler.
Funds that allow managers to take short positions as well as long, often called 130/30 or short-extension strategies, had been tipped by some as the future of stock investing. But the August market turbulence hit the biggest managers of these strategies especially hard, hammering home the risks to investors and dampening likely growth prospects for what many investment firms had counted on as a money-spinning sector.
"Investors will put less money in these strategies," sums up Harindra de Silva, president of Analytic Investors in Los Angeles and co-author of an influential 2004 paper, "Toward More Information-Efficient Portfolios," that helped start the trend. His firm runs about $2 billion in short-extension funds, ranking it among the biggest providers in a market that has grown -- seemingly overnight -- to $75 billion under management.
Driven by demand from institutional investors looking for better performance in a low-return environment, money managers around the globe rushed to launch their own versions of short-extension funds, which combine the market exposure of traditional, long-only funds with shorting techniques borrowed from the hedge fund world. (The strategies are often called 130/30 funds in reference to the proportion of long to short positions.) They command higher fees than traditional funds and sometimes lucrative performance fees as well.
In their short history the market's expectation -- and appetite -- for these strategies had seemed unlimited. As recently as last month, financial research firm TABB Group estimated that the market could soar to a massive $2 trillion in assets by 2010; it based its estimates on interviews with equity managers who had launched such funds. Growth on that scale would have made them one of the most successful new product launches in investment history, outstripping even the wildly popular exchange-traded funds, which hit $688.8 billion in assets worldwide at the end of the first half of 2007, according to figures from Morgan Stanley, 14 years after they were first launched.
But the August market turmoil has dulled the sector's luster. In this first real test for short-extension funds in difficult markets, many struggled. It didn't help that the leading players in the 130/30 space have been quantitative firms; they were hit especially hard as their computer models got flummoxed by the volatile market swings. Some of the biggest names in short-extension funds -- State Street Global Advisors, Barclays Global Investors, Goldman Sachs Asset Management and Deutsche Asset Management -- suffered.
Indeed, only three of the 38 investment vehicles that use short-extension strategies tracked by performance-rating firm Morningstar did better than traditional long-only indexes like the Standard & Poor's 500 in August. The worst performer, the 120/20 Old Mutual/Claymore Long-Short Fund, run by Analytic Investors, ended the month down 3.53 percent, compared with the 1.5 percent rise of the S&P 500 index. Year-to-date to the end of August, the funds fared better; six out of 20 for which Morningstar had data outperformed their benchmarks.
"The first nine days of August were atrocious," says Russell Kamp, head of structured products at Invesco in New York, which runs about $800 million in short-extension funds launched in the first quarter of this year. "We underestimated the level of risk, like everyone else, and that was disconcerting."
Funds that use leverage, take short positions and invest in small-capitalization stocks took the worst falls. Invesco's 150/50 small-cap core equity fund fell about 14 percent in the first two weeks of August, for example, while its 130/30 large-cap core portfolio dropped about 6 percent, says Kamp. Invesco held its course, betting on a rebound. The small-cap fund ended August down about 1.7 percentage points against its benchmark, the S&P small-cap 600 index, while the large-cap fund was down about 52 basis points compared with the S&P 500 index. Invesco's equivalent long-only funds outperformed their benchmarks.
Understandably, investors have blanched at the unexpected volatility. Says Richard Boersma, executive officer at the Kansas City Employees' Retirement System, who plans to invest in global stock 130/30 funds: "It has made us more cautious and will result in us performing additional due diligence. These products had been marketed as a free lunch, and we all know somebody pays."
Kamp acknowledges: "Many plan sponsors were getting into these products without understanding the potential drawdowns. We're seeing less interest now."
It's a similar story at other quantitative managers. Although she declined to give specific performance figures, Arlene Rockefeller, head of global equities at State Street Global Advisors in Boston, estimates that 70 percent of the firm's 130/30 portfolios underperformed their benchmarks in August and that 50 percent underperformed for the year through August. State Street is thought to be the biggest manager of 130/30 funds worldwide, with about $10 billion in assets.
"All quantitative managers are finding this a challenging time," admits Michael O'Brien, head of the European institutional business of Barclays Global Investors, the San Franciscobased firm that manages about $7 billion in short-extension strategies. He expects a slowdown in new business as a result of the August losses. "There will be a period of reassessment of any strategy that moves away from the comfort zone of traditional long-only management," he says.
Blue Sky Group of the Netherlands, which manages about E12 billion ($17 billion) for pension funds, including that of KLM Royal Dutch Airlines, is one wary investor. The group has allocated about E400 million to a quantitatively managed 130/30 fund and a 110/10 fund and is considering shifting more into these types of strategies. Now Blue Sky is reexamining the performance of some 40 short-extension funds worldwide. "It concerns me that a lot of quantitative managers have the same factors in their models, making it more difficult to diversify among them," says Ramon Tol, equities fund manager at Blue Sky.
Quantitative funds will face the most scrutiny because they dominate the 130/30 market, potentially creating more opportunities for rivals that adhere to a fundamental investing approach. Until now the quant funds successfully argued that because they already ranked all stocks in their benchmarks, they had an easier job picking stocks for shorting. Traditional fund managers typically look for stocks they like rather than those they expect to underperform.
Any retreat by pension plans from short-extension funds would be a setback to money managers who had hoped these products would help fight off competition from the hedge fund industry. Managers of short-extension funds typically charge higher fees than for long-only products, making them more profitable.
Eager to do battle with hedge funds, investment managers around the globe have rushed to launch their own versions of short-extension funds in recent years. The biggest, State Street, launched its first 130/30 strategy in Australia in December 2004, and Kanesh Lakhani, the London-based head of the firm's U.K. business, thinks State Street could eventually launch funds covering all the developed markets in the world. More than 40 other managers offer short-extension products, including AQR Capital Management, Barclays, Goldman Sachs and Jacobs Levy Equity Management.
The big managers that do not already run 130/30 products have been busy making plans. AllianceBernstein, part of French insurance group AXA, aims to launch 130/30 funds by the end of the year, and Morgan Stanley Investment Management is thinking about its own initial offering. Recent new products include JPMorgan Asset Management's July launch of four new short-extension funds for European institutional investors, as well as four similar funds targeting U.K. retail investors. In the same month, UBS started selling its 130/30 fund investing in U.S. stocks to U.K. investors and plans to follow that with a similar fund investing in U.K. equities by the end of the year. In August, F&C Investments launched its Enhanced Alpha U.K. Equity fund, and in September both BlackRock and Invesco announced 130/30 funds investing in European stocks.
Investment managers will have to work harder than ever to win over often-skeptical investors. "130/30 funds give you neither a long-only nor a hedge fund strategy," says a skeptical Ronald Wuijster, head of strategy and research at ABP of the Netherlands, one of the world's largest pension funds, with E209 billion in assets, and a big investor in hedge funds. "They are just the latest hype from investment managers. The performance of these funds has so far been disappointing."
"These funds are flavor of the month, and that doesn't usually end well for the majority of investors," says Todd Trubey, a senior fund analyst at Morningstar in Chicago. "It's a nice story, but at the end of the day, shorting takes special skills.''
With short-extension strategies, the fund manager invests in a basket of stocks, say the S&P 500 index, and then shorts a certain percentage, most commonly 30 percent, but that can vary, usually from 20 percent to 50 percent. The proceeds from the short sale are used to add the equivalent of long strategies, typically giving 130 percent long exposure.
The appeal for investors, say backers of these funds, is that managers can put more money behind their convictions by making bigger underweight and overweight active bets relative to their benchmarks. By contrast, the only way the manager of a long-only portfolio can express a negative view of an S&P 500 stock is to not buy shares in the company.
"The ability to take even modest short positions is an important structural advantage that can be used to improve the information efficiency of traditional long-only portfolios," Roger Clarke, de Silva and Steven Sapra, principals of Analytic Investors, wrote in their influential 2004 paper, published in the Journal of Portfolio Management, a sister publication of Institutional Investor.
"Traditional active managers are not offering as much risk and opportunities to generate alpha as they did in the past," says Robert Jones, head of Goldman Sachs Asset Management's quantitative equities group in New York, which manages $2.1 billion in short-extension funds. "These strategies give higher risk without the inefficiencies of a concentrated portfolio."
But when the stock picking goes wrong, these short-extension funds can take big hits. Watson Wyatt Worldwide director of investment management research Jeffrey Nipp cautions investors that 130/30 funds are effectively as risky as a hedge fund. "Clients need to understand how much pain they may have to endure to get the outperformance they expect," he says.
"There's no denying that this is a higher-risk product than traditional long-only funds," notes Fiona Dunsire, head of the U.K. business of Mercer Investment Consulting in London. The extra risk comes from shorting, because a wrong bet could mean potentially unlimited losses as stocks rise. Borrowing stocks for shorting also exposes the fund to the risk of a short squeeze, when short-sellers cause a stock price to rise by trying to cover their short positions.
That's what happened in August. Losses got amplified when many computer models turned out to have been betting on the same stocks. "I didn't realize how much of a common thread ran through quantitative strategies," says Analytic Investors' de Silva. His firm's Core Equity Plus 120/20 fund fell 0.35 percent in August, compared with the 1.5 percent return of the S&P 500 index, according to Morningstar.
"We quickly realized that fundamentals were not driving performance and that instead it was in the market deleveraging," says Invesco's Kamp. He cites big swings like the 32 percent drop in the stock of well-regarded small-cap printing company Deluxe Corp. in the first two weeks of August while New York Stock Exchangelisted homebuilder Hovnanian Enterprises rose more than 34 percent in a couple of days despite fears about the housing industry.
To profit from any rebound, Invesco decided not to liquidate positions, but the firm is making changes to its investment models. By analyzing the performance of its funds, Invesco has identified some factors that it believes other quantitative funds were not using.
Deutsche Asset Management launched its quantitatively managed 120/20 funds in November 2006, and the large-cap funds underperformed their benchmarks by between 2 and 3 percentage points to the end of August, according to Janet Campagna, global head of the firm's quantitative strategies group in New York. She says she's sticking to the same investment model, however, and insists that planned enhancements in October "are not in reaction to recent events."
"We take a much longer-term view," Campagna says. "This was an unusual period, with markets driven by liquidity concerns, that was difficult for many models." Deutsche screens stocks using roughly ten factors that include earnings, cash flow, momentum and other measures of market sentiment.
Goldman Sachs Asset Management's quantitatively managed long-short hedge fund suffered high-profile losses in August; its short-extension funds that use similar strategies suffered too, though less dramatically. The Goldman Sachs Structured U.S. Equity Flex fund fell 2.68 percent year-to-date to the end of September, during a period when the S&P 500 index rose 9.13 percent, according to Morningstar.
One lesson for pension funds is not to hire several quantitative managers running short-extension funds with similar models. "It's very important that investors get diversification," says Campagna. "They need to look more closely at the correlation of different managers."
That may in turn create opportunities for traditional active stock pickers. Until now pension funds have favored quantitative firms over fundamental firms that rely on the human skills of fund managers to research companies. The theory was that because the quants' models systematically screened all companies in their universe using criteria such as valuation, earnings quality and analyst sentiment, they could just as easily select stocks to short as stocks to buy, whereas the fundamental managers had little experience picking shorts.
"These strategies are a more natural fit for quantitative managers because they already generate a ranking for every stock in their universe," says Eric Baggesen, a senior portfolio manager at the California Public Employees' Retirement System. "Traditional long-only managers have historically spent more time identifying securities they like than securities they don't."
Last March, CalPERS allocated about $3.2 billion, or roughly 2 percent of its global equity portfolio, to three quantitative managers running 130/30 funds investing in U.S. stocks: Analytic Investors, State Street Global Advisors and Quantitative Management Associates. CalPERS says it is too early to judge the performance of the managers because they were only funded in the second quarter. But long term the pension fund expects these 130/30 funds to outperform their benchmarks by between 150 and 350 basis points annually. "We need to gain comfort that this is a value-added strategy," Baggesen says.
Still, investors may seek fund managers with different styles and not just quantitative managers. "Investors got a real surprise," says de Silva. "They thought they had hired managers who were substantially different and were surprised that everyone did poorly."
That could boost traditional managers running short-extension funds. To be sure, some human stock pickers had disappointing returns. The UBS US Equity Alpha mutual fund returned 5.35 percent year-to-date through the end of September, compared with the 9.30 percent return of its benchmark, the Russell 1000 index, according to Morningstar. The ING 130/30 Fundamental Research Fund returned 6.69 percent over the same period.
But others, like JPMorgan, which manages $2.7 billion in 130/30 funds, looked stronger. JPMorgan's U.S. Large Cap Core Plus Select fund posted a 16.57 percent return through September. JPMorgan says the funds held up better than other similar strategies in August partly because they were overweight large-cap growth stocks and underweight financials.
"Our ideas come from our research team," says Paul Quinsee, JPMorgan's chief investment officer of U.S. large-cap core equity in New York. "We can use our insight to create value that you would not get from a computer."
But whether driven by humans or computers, investors just got their first taste of the true risks of investing in short-extension funds. "The rationale for investing in 130/30 funds hasn't gone away," says Andrew Doman, a consultant at McKinsey & Co. in London. "But investors will definitely be more cautious." At least until many of these funds have reestablished strong track records.