Implementing 130/30 strategies creates negative alpha from the start, said Thomas Kirchner, a portfolio manager at Pennsylvania Avenue Event-Driven Fund, a Washington, D.C.-based mutual fund that practices short selling. On his blog, The Deal Sleuth, Mr. Kirchner posted a paper he wrote that stands in stark contrast to the recent hype around 130/30 products in the asset management industry.
In the post “Negative Alpha Is Built Into 130/30 Funds,” Mr. Kirchner wrote that the problem with 130/30 funds is that they invest all the money they have. So in order to short, they have to borrow. And that comes at a cost.
In theory, the manager of a 130/30 fund goes long using 30% leverage and then shorts the same amount, which gives the portfolio a total long/net exposure of 100%.
But in an interview, Mr. Kirchner said that most of the advocates of 130/30 funds—prime brokers, asset managers and sell-side analysts—fail to provide the whole picture. The investor, he said, is told that in addition to placing 100% of his principal in an index, 30% of the invested amount will be sold short, and that the proceeds of the short sales will be used to acquire a 130% long position. The net exposure is still only 100% and generates pure beta, while the long/short component of the portfolio is supposed to generate some alpha. That’s the concept.
The reality can be quite different, he said. Since all of the money is invested in long positions, the manager must deposit the proceeds of the short sale (or some of them) with the broker that holds the short sale. In comparison, a hedge fund running a market neutral strategy will have 100% shorts and 100% long and will be able to use his long position as collateral for the short sales.
Mr. Kirchner offered another way to explain his concept. An investor in a 130/30 fund is fully invested in an index fund and acquires an additional alpha-generating overlay. Because the money is fully invested, the investor cannot obtain additional returns out of nothing without incurring a cost, he said. This cost comes from borrowing the securities for the short sales. Mr. Kirchner called it “negative alpha” because it eats up whatever alpha is generated.
Josh Galper, managing principal at Vodia Group LLC, a New York-based research firm that has produced research reports on securities lending, agreed with the technical argument offered by Mr. Kirchner. “It’s true that in the case of a 130/30 strategy, you have to jump the margin hurdle for that extra 30%. That is absolutely correct,” he said.
Since the 130/30 manager needs to borrow collateral—due to the fact that the long position exceeds the shorts—the manager must then pay the broker interest, which is the cost of borrowing the securities. This cost is lessened by another factor, though. The fund manager earns some money for letting the broker use the short sale proceeds as what would be the equivalent of a deposit. This is known as the “short rebate” in industry parlance. However, Mr. Kirchner said, the difference between what the manager pays in interest to the broker as his borrowing cost and the short rebate he earns from the broker is negative. As a result, the implementation of a 130/30 strategy starts with negative alpha, he said.
That argument may not be popular. 130/30 funds are the latest fad to hit the money management industry, and hardly a week goes by without a big mutual fund company or a well-known quantitative investment manager launching an “extension strategy,” as 130/30 funds are also known.
They are in demand today because institutional investors want some alpha without having to make a first foray into hedge fund investing or without having to ask their boards for permission to boost allocations to the hedge fund bucket. Implementing a 130/30 strategy is a smoother transition into alternative investing for many pensions, one that can nicely fit into an existing equity bucket.
Prime brokers love it, too, as they can attract new lending business. 130/30 funds can be large, since they can be sold as mutual funds or in the form of separate accounts to large pension funds. It is certainly an additional source of earnings for the banks that already make nice profits lending to hedge funds, though the lending business has slowed down recently due to the credit crunch.
A number of sell-side research departments have produced research papers on 130/30 funds, including Goldman Sachs Group Inc., one of the first banks to implement the concept.
But Mr. Kirchner said the cost of shorting is simply ignored in 130/30 literature. This cost is hard to assess, said Mr. Kirchner, because it depends on so many different variables such as the extent of the long/short portion, the interest rate spread and the amount of short sale proceeds withheld by the broker. For instance, Mr. Kirchner said he saw some of the short rebates vary between 0% and 2%.
But the worst problem is the lack of disclosure regarding the cost of shorting, not just in the sales presentations touting short extension strategies, but even in the prospectuses. Often figures in footnotes will be too vague or incomplete, he said. In other cases, the disclosure—for instance in master funds—will be of no use because the prospectus will wrap several funds into one filing, making it impossible to know where the collateral sits or what the amount of the short rebate is, he said.
“The logic behind these 130/30 strategies is that you get 100% exposure to the market, and on top of that you get alpha for free,” Mr. Kirchner said. “But there is a cost in implementing those strategies that ultimately shows up in the return.” That cost, however, is not generally part of the sales presentation.
Hedge funds are more upfront about the cost of alpha, Mr. Kirchner said. “A hedge fund does not promise that you’ll get alpha plus something. The concept is that you’ll capture whatever comes from the long and short trades. Whatever alpha is generated you’ll pay for it. It’s understood as being the cost of getting alpha,” he said.
So while investors may not be fully aware of how much the short-selling part of a 130/30 strategy costs them, prime brokers are fully conscious that they’re increasing and diversifying their revenues with this new securities lending jackpot.
It’s no wonder the banks are pushing 130/30 products so hard, said Mr. Kirchner. But what’s in it for investors is another question, he said.
“Investors in 130/30 funds should be wary of funds offered by large financial services institutions with affiliated brokerage and lending operations,” he said. “The temptation of squeezing extra margin out of a 130/30 fund through low short rebates and high lending rates could be too great for bonus-hungry executives to resist. . . . We would look at short extension funds for the next big mutual fund scandal.”
To make matters worse, there is no real performance data on 130/30 funds since they are so new, even though some theoretical studies have been made based on back testing. But then again, Mr. Kirchner said he is skeptical of those quantitative studies, arguing that they fail to take the cost borrowing cost into consideration.
Investors’ fascination with 130/30 funds is likely to continue for a while, though. “The financial industry is a cyclical fashion industry,” Mr. Kirchner said. “Why did everybody do subprime and residential mortgage securities? And why are they doing 130/30 today? Tomorrow, they’ll be doing something else.”
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