130/30 poised to hit retail market

One of the most popular institutional investment strategies, the 130/30, is making its way into the retail market. Last week, UBS launched the first pair of 130/30 funds in the world aimed at this market segment. Although these types of funds are not approved for the average individual investor in Canada yet, industry observers say it’s only a matter of time.

At the heart of the 130/30 strategy is the ability for the manager to generate alpha through a combination of short positions and long positions. The strategy is common among hedge funds and institutional investors.

The mettle of a portfolio manager is tested by his or her ability to achieve alpha, which are returns in excess of a market benchmark. For example, it would be a seemingly impressive feat if a fund manager of a large-cap U.S. equity fund can post a return of 18%, but if the S&P 500 rises by 20%, then the manager has not demonstrated any value to his investors.

“If you look at the S&P data and see how many managers fail to outperform their benchmarks, last quarter probably two-thirds of the active managers failed to beat the S&P,” says Angelo Calvello, executive-vice president of Chicago-based Man Investments. “Institutional investors recognize this, and they are looking for a better way.”

For institutional investors, achieving alpha has become a prerequisite, Calvello says. The three-year market downturn that started in 2000 may seem like ancient history to most investors enjoying the current bull-run in equities, but institutional investors have not forgotten.

As their investments slid in proportion to the market indexes, they realized that in most cases, the money they forked over to a money manager was not generating any excess returns. Now they insist that if times are good, they’re doing great, and if times are poor, they’re still ahead of the game.

Enter the 130/30 strategy, which Calvello says is probably the simplest of a newer breed of popular institutional investing strategies that have a built-in investment component purely concerned with achieving alpha. Calvello says the 130/30 is the most common of similar short–long strategies known as “Beta 1” strategies that attempt to achieve alpha through the use of shorting undervalued stocks listed on its benchmark index.

The standard 130/30 strategy works as follows: the investor invests $100 in an equity fund tied to a given benchmark index. That $100 will be invested in its entirety in the traditional active strategy of investing in undervalued stocks that the portfolio manager expects to grow in value. The fund manager will then borrow $30 worth of equities for every $100 dollars invested in the fund, shorting the most overvalued stocks in the index.

The equivalent of another $30 from the shorted stock sale is then reinvested into the long position, creating the 130 long to 30 short ratio, which gives the strategy its name.

Scott Bondurant, global head of long–short investment for UBS Global Asset Management, says the strategy takes advantage of the expertise of fund managers to add value to the portfolio by allowing them to follow their intuition on stocks they feel are overvalued. For most indexes, it’s not worth the effort to dump the overvalued stock because it represents a very small fraction of the market index it’s listed on, he says, but by shorting those stocks, you can magnify this difference to generate substantial returns.

Bondurant explains that the UBS U.S. 130/30 Equity Funds, one of UBS’s retail 130/30 funds that has received approval in the U.K., can more than double the returns of an undervalued stock versus a traditional long-only U.S. equity fund.

“More than 80% of the Russell 1000, which is what our benchmark is, has a value that is 15 basis points of the index or less,” he says. “If it’s only worth 15 basis points, I don’t want to own it, and I just won’t own it. In this case, if the stock were to go down 50% then you would add about 7 to 8 basis to the portfolio.

“If you relax that constraint and take a 100 basis point short position, were the stock to go down, you would add 50 basis points to your portfolio, which is a big deal.”

Bondurant says that on the institutional side, the U.S. 130/30 fund has consistently outperformed its U.S. large-cap long-only fund.

“We’ve been able to use this strategy in the U.S. with annualized returns of 20%. That’s in comparison to our regular large-cap strategy, which has provided returns over the same period of about 17.99% annually, and that’s again higher than the Russell 1000, which has returned 16.3%.”

UBS thinks that for retail investors, the strategy will catch on very quickly, because of its track record and its relative simplicity to understand. Regulators in many nations are not ready to open the door to retail investors yet because the strategy is not without risk.

In a standard long-only equity fund, most of the fund’s performance will be tied to its benchmark exposure. If the market drops, even the most skilled managers will be hard-pressed to realize gains. With the short position added to this portfolio, there is the additional risk, since the investor is on the hook for gains in those shares.

Like any type of leverage, it will magnify gains as well as losses. If the short position is poorly executed, it will add additional magnified losses on top of the market losses.

Bondurant admits the short position adds to the investor’s risk, but only slightly so in the hands of a skilled manager.

“You have a chance to outperform or underperform a little more relative to the benchmark. We clearly do not view this as a hedge fund or an alternative investment,” he says. “We consider this investment as an extension of our traditional long process. I think that’s the view of the vast majority of the 130/30 managers out there.

“We already have a Canadian vehicle that we have just marketed to institutions. I believe that we’re compliant with retail regulations as well.”

As an easy to explain equity product with a proven reputation with instiutional investors, Mark D’souza, vice president of RBC Capital Markets works with company’s prime brokerage says the entrance of 130/30 into the retail market is not a matter of if, but when.

“Morgan Stanley estimated that next year, between $30 billion and $40 billion will be invested in these products globally. It is just a matter of time before it gets popular in Canada,” he says. “Institutional investors are the most sophisticated and are always the first to step in. Gradually, as the strategy gains acceptance in the wider investment community, you’ll find that the retail investors are going to be creeping in.”

Filed by Mark Noble, Advisor.ca, mark.noble@advisor.rogers.com

(07/10/07)