Theoreticians argue the 130/30 strategy - which combine a traditional long-only portfolio with a 30 per cent long / 30 per cent short portfolio - produce alpha more efficiently.
The logic behind the strategy is flawless, according to a recent FT piece by John Authers, which explains why it has gained favour with plan sponsors and is moving into the retail investment bloodstream. Pension managers have been early consumers of 130/30 strategies, and are responsible for most of the estimated $50bn invested therein.
Quant managers at larger US firms such as State Street have been early providers, in many cases, in part because their stock-ranking strategies lend themselves to shorting. But fundamental managers and hedge funds are also increasingly offering or considering the portfolios.
“[130/30] captures the single greatest advantage of short selling - that it enables managers to profit from stocks that go down as well as up. But it also counters the greatest objection to short selling, which is that in the long run stocks go up, and it is better to be fully invested in the market. With a 130/30 strategy you are effectively 100 per cent exposed to stocks,” Authers said.
Merrill analysts view the proliferation of 130/30 portfolios as a positive, since they will add to the repertoire of traditional managers and should produce greater flexibility and innovation. “Fees are attractive,” they write, “as the format emphasises asset manager skill.”
But for both Authers and Merrill, nagging doubts remain.
The greatest downside, according to Authers, also applies to all other strategies: 130/30 needs to be executed well. “There are more opportunities to make mistakes than with a long-only strategy,” he says. “If the flood of offerings grows much greater, there is a real danger that managers without the necessary skills may be able to raise money.”
For Merrill, the hybrid portfolios could add risk control and compliance costs, and a flood of introductions could prevent some from gaining scale or pressure fees. Moving away from long-only investing requires more sophisticated systems, Merrill’s analysts note, with a much heightened stress on risk measurement.
Mainstream managers might also initially find it tough to convince investors that they have the skills necessary to run short as well as long strategies. “There is no magic wand that can be waved here; our view is simply that managers should get funds up and running, so that they can build track records in a public format,” says Merrill.
Authers quotes Alistair Sayer, investment director at Henderson Global Equities, who points out that 130/30 is not a natural extension of the skill set of a conventional active fund manager who is looking for a hundred or so stocks that will go up. These strategies undeniably give more opportunities to go wrong, so those unskilled in selling short should not attempt it.
Finding alpha is, in Merrill’s view, the greatest challenge. “In the search for alpha, some will find it and some will not, and the purer the product, the clearer this will be. In Lake Wobegone, all children are above average, and no doubt all fund managers are alpha generators, too. Sadly, in New York, London and the like, they are not; nor can they be.”
As a final point, Merrill’s analysts flag the risk of potential marketing confusion. “Some will view them—mistakenly—as absolute return portfolios. They are in fact high-conviction long portfolios, but their use of shorting may confuse some, and some may mistakenly view them as narrow niche substitutes for absolute return,” they said. “Eventually however we believe they will be increasingly substituted for long-only mandates.”
But a little scepticism has to be healthy, Authers concluded, which has to be a sensible position to take..
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