CutterAdvantEdge

Issue 57, March 2008

In Search of Alpha: 130/30 Funds

The volatile market conditions that continue into 2008 make it challenging for traditional asset managers to develop winning investment strategies. So increasingly, they are venturing into what has traditionally been hedge fund territory. Some have developed hedge funds of their own. Some have acquired existing hedge funds. Others have found success introducing short extension structures, exemplified by the 130/30 fund.

Short extension structures go by a host of aliases, including active extension, alpha extension, leveraged net long, enhanced alpha, high-conviction funds, beta-one funds, limited-shorting funds, long-enhanced funds, active extension funds, hedge-fund lite, 1X0/X0 and 1XX/XX.

The current market for 130/30 funds is estimated at $50 billion. According to projections published by Merrill Lynch, the market will grow to as large as $300 billion in three years, and possibly to $1 trillion in five years. These estimates assume that up to 20% of institutional assets will be allocated to short-extension structures on the five year horizon, and that US assets are roughly equivalent to non-US assets.

In our recent CutterBenchmarking™ survey on Alternative Investment Strategies, 42.8% of respondents said they already offer 130/30 funds, and 28.6% expect to offer them within three years. The majority of those already offering 130/30 funds have done so in reaction to strong client demand and because 130/30 funds represent an opportunity to improve returns on traditional strategies.

Traditional asset managers using quantitative investment methods are well-suited for adding these ”limited shorting” strategies to their portfolios. Because their quantitative models rank stocks from best (overweight) to worst (underweight), the projected underperformers thereby identify where they should be shorting the portfolio.

In a 130/30 fund, 130% of the fund's net asset value is invested long, with the extra 30% funded by shorting securities outright or by investing in derivatives. This structure supports "finding alpha" by holding favorable stocks long and holding stocks not in favor short, so that the fund achieves returns from both downside and upside market movements.

System requirements for managing 130/30 funds are similar in many ways to traditional investment processing systems. Existing systems can typically support most of the standard investment processing life cycle including deal capture, trade processing, middle office, accounting, performance/attribution, and reporting. This is true regardless of whether the 130/30 fund is offered by a hedge fund or a traditional asset manager, or whether quantitative, fundamental, or combination stock-picking methods are used. Although systems and processes already in place for long-only funds provide most of the functionality for a 130/30 fund, you should still re-evaluate your existing systems and processes. When doing so, the following are some thoughts on issues to be analyzed:

 

 

  • Do your existing systems directly support or offer streamlined entry or import facilities for short sale transactions and for derivatives that may be required to implement the fund?
  • Do your existing pricing feeds provide your portfolio managers timely P&L for the day’s activity and holdings?
  • Do profit and loss calculations adequately consider the cost of borrowing in deriving values on short positions?
  • Do your existing systems provide useful metrics on portfolios, including the separation of long and short positions and the ability to group holdings by strategy within a portfolio?

Compliance

  • What look-through facilities do you have for position reporting or compliance review, where exchange traded funds or derivatives are used to achieve exposure to benchmark securities or to synthetically achieve shorting impact?
  • What guidelines are in place to ensure that short extension funds allow shorting only within their allotted restriction (for example, 30% for a 130/30 fund)?

Valuation and Risk

  • Do your existing valuation methods ensure fair pricing for all securities held in the 130/30 fund, including derivatives?
  • Do you have adequate pricing feeds and data fields to track this information?
  • Will risk evaluation consider discrete long and short positions, and also evaluate and report baskets of securities by strategy?

Fund Accounting

  • Do the systems in place provide adequate functionality for short sale transactions and for derivatives?
  • For hedge funds, does the accounting system provide required partnership accounting facilities and support for generating tax statements?
  • What facilities do you have for viewing positions in groups (such as by strategy)?

While it is not yet clear if 130/30 funds will attain their projected growth, it is safe to say that the performance of the current crop of 130/30 products will be closely watched to see if alpha is achievable. Regardless, there will be increasing demand for managers to provide more alternative investment vehicles to their clients in the future. This will present increasing challenges to the systems and operations areas to enhance their systems and processes to mitigate the additional risk associated with this trend.