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| Risk & Reward: Strategy: |
Balancing Act
John Ferry
05/01/2007
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Wealth managers are touting a new
strategy for investing in equities that delivers the kind of excess returns
usually associated with hedge funds without venturing too far from traditional
long-only practices. Often referred to as 130/30, the strategy works like this:
Prescient asset managers increase risk-adjusted returns by going short, while at
the same time taking longer stock positions thought to be undervalued. "A
traditional long-only manager takes advantage of undervalued ideas in his or her
investment process. A 130/30 manager not only takes advantage of those
undervalued ideas, but can also take advantage of overvalued ideas as well,"
says Scott Bondurant, executive director and long-short equity strategist at UBS
Global Asset Management in Chicago. In their search for elusive alpha
returns—excess return attributed to manager skill—pension funds around the world
are said to be buying into the strategy, while it is also being marketed to
affluent individuals and families.
TOP VIEW
Prescient asset man-agers use what is known as a 130/30 strategy
to increase risk-adjusted returns by going short while simultaneously taking
longer stock positions thought to be undervalued. Because 130/30 returns are
designed to move in line with the broad stock markets, investors often employ
the strategy as a replacement for long equity positions, rather than a
substitute for a hedge fund or other absolute-return allocation. Although the
strategy is easy to access—some mutual funds now embrace it—it does come with
risk. If the asset manager executing the 130/30 is bad at picking stocks,
investors can lose substantial sums very quickly. |
By definition, a long-only manager who takes a negative view of
a particular stock’s prospects can only express that sentiment by underweighting
the company in his portfolio. But let’s assume a particular manager is highly
skilled at identifying stocks that subsequently perform poorly compared with the
rest of the market. If he underweights a particular stock by placing less or no
money in it, and instead invests a higher proportion in the stocks he believes
will outperform, then he will create some excess return above whichever
broad-market benchmark he is measured against.
This assumes, of course, that the manager turns out to be a
wise stock picker. The problem is that the amount of excess return that can
actually be realized through such underweighting is usually insignificant. "In
the Russell 1000, 830 names have a market capitalization that is less than 0.13
percent of the total capitalization of the index," Bondurant says. "That means
that, effectively, if you identify a name as being overvalued in a long-only
portfolio, then you can’t take advantage of it because it’s too tiny, as are the
vast majority of the names. They are so tiny that just avoiding them doesn’t
help you relative to the benchmarks."
Therefore, rather than simply staying clear of the negative
stocks, a manager can seek to actively profit from his negative views by
shorting those companies (see "Going Short"), thereby making money when
their price falls. What’s more, when the manager shorts stocks, he releases cash
that can then be used to increase his exposure to the companies he likes. This
is the essence of the 130/30 strategy. With a 130/30, the manager can short up
to 30 percent of the portfolio, either physically or by using derivatives, while
gearing up to 130 percent on the long portion. In essence, the manager can
leverage his views.
Picking a Winner
The term 130/30 is actually a bit of a misnomer—the market has
still not arrived at accepted nomenclature for the strategy. At the moment, most
managers seem to refer to any fund offering this type of exposure as a 130/30,
but, in fact, the long-short constraints could just as easily be set at 120/20
(120 percent long and 20 percent short) or 140/40. Some institutions have tried
to coin proprietary names for their products. Morgan Stanley refers to the
strategy as "active extension," while State Street calls its offering "edge
strategies." Still others refer to it as "short extension" or "enhanced active
equity." It carries a confusing amalgam of names, but for now, the most common
term used when talking about the strategy is 130/30, and any capable portfolio
manager or advisor should recognize it.
"If you’re not confident that a manager can outperform the
index, then a 130/30 strategy isn’t going to make him outperform the
index." |
A closer look at its risk-and-return profile shows that
although 130/30 is designed to increase the excess return the investor receives,
it is still far removed from the absolute return strategies of hedge funds. A
long-short equity hedge fund should make the vast majority of its returns from
alpha rather than beta (the return from simply taking a long position in the
market as a whole, which could easily and cheaply be gained from buying an
exchange-traded fund, for example). A 130/30 fund, however, is explicitly
designed to retain broad-market exposure while increasing alpha opportunities.
In professional parlance, while an absolute-return hedge fund should have a beta
of close to zero, a 130/30 fund manager always strives to have a beta of roughly
one. "You know you’re going to get beta through this portfolio, but you want the
manager, by relaxing the short-only constraint, to create a more efficient
portfolio construction," says Ben Scott, an executive director with Morgan
Stanley in New York. Scott adds that even though an investor may be going short,
by balancing out the underweight and overweight positions, his net market
exposure remains at 100 percent, which means it is not an absolute return
strategy, so it is not designed to always produce positive returns.
"This is a benchmark-relative product," says Alistair Sayer,
investment director with Henderson Global Investors in London. If the equity
market as a whole goes up by 8 percent over the year, for example, a well-run
130/30 strategy should earn that 8 percent plus some excess return. If, however,
the broad market falls 8 percent, then the successful 130/30 would still fall,
but by an amount less than the 8 percent long-only return. So if the strategy
delivers as it was designed to, it should always outperform the broader market
benchmark. Because the returns are still designed to move in line with the broad
market, investors often use 130/30 as a replacement for long equity positions,
rather than a substitute for a hedge fund or some other absolute-return
allocation. "We view this squarely in the traditional equity category, not as an
alternative investment," Bondurant says. "We hope that with this strategy we
will provide better returns than not only an index, but also a traditional
long-only strategy, for a similar level of absolute risk."
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