A new buzz word: 130/30

Australian Financial Review, March 2008

A new buzz word has been appearing in fund management circles around the world over the last 12 months – or perhaps a buzz number would be a better description. It’s “130/30”, and if you haven’t heard of many such funds yet, you will.

130/30 refers to a style of investment in which a fund manager can take both long and short positions in the market. A long position is when you buy a stock in the hope that it will go up in value – how most of us invest. But a short position involves profiting from a fall in value in a stock.

There are many long/short funds in Australia which allow managers to do exactly that: back the stocks they think are going to rise and position themselves to make money from others that are going to fall. Fund managers like the idea because it gives them much greater freedom to act on their opinions about how stocks and markets are going to move.

But 130/30 funds are something more specific than that. The 30 refers to the percentage of the fund that is permitted to go short. When you short a stock, you sell a stock you don’t own in the hope of buying it back at a later date and at a lower price. The funds you receive for those short positions, representing 30% of the portfolio, can then be invested in long positions, which is where the 130 comes from. One advantage of this is that, by investing $100, you get a total of $160 of exposure to the market, $130 of it long and $30 of it short.

Another reason 130/30 has taken off is because in terms of exposure to the market, the figure remains constant: 130 long minus 30 short comes out as 100 per cent, just like a mainstream, long-only fund. In the technical jargon of the funds industry, this is known as having a beta of one. That’s not the case with long-short funds which can end up all over the place in terms of their overall exposure depending on whether they are mainly using long or short positions at the time. For big super funds in particular, that can be problematic, as they want to keep their allocations consistent.

For these reasons, super funds in Australia have been very active buyers of 130/30 products, or have given mandates to fund managers to invest in this way. Hesta, a leading industry fund, is one example who uses managers including Acadian Asset Management, Axa Rosenberg and AQR Capital Management, all based in the US. Acadian secured the early involvement of another industry fund, Hostplus, which seeded its 130/30 strategy in Australia; it also has mandates for Care Super and Just Super.

“It’s a more efficient way of implementing manager skill,” says Chris Clayton, CEO of Acadian Australia, which is owned by the US group Acadian Asset Management and by Colonial First State. “If you can invest in stocks that you think will go up and short stocks that are going to go down it increases your investable universe and makes your outlook in terms of stocks much more symmetrical.” It also frees the manager to take some more unusual positions than they would normally be able to do. If a manager likes a fairly volatile small cap stock, in a traditional long-only fund it would be difficult to put much money into it without unbalancing the risk profile of the whole fund. In a long-short, the manager could take a short position on another stock with similar characteristics, “trying to net out the common risks,” Clayton says.

And the risk profile is also more manageable for investors than a regular long-short fund, he says, because the exposure to the market overall remains consistent. “The gross leverage means managers have the potential to outperform by more – and therefore to underperform as well – and the fixed market exposure means you have confidence your exposure to the market is not going to swing around.” Institutions in Australia have been so enamoured with this approach that Acadian filled its allocation to them nine months ago and is now only open to retail money, where it sells through the FirstChoice platform.

Another US manager to have benefited greatly from the growing enthusiasm for 130/30 is Axa Rosenberg. This manager, founded by investment academic Barr Rosenberg, focuses only on global equities and today runs around $5 billion of Australian-sourced money, chiefly for the bigger super funds.

Doug Burton, managing director and head of investments for Australia and New Zealand, says that institutions in Australia are using it not as an alternative to long/short funds, but an alternative to long only mandates. “They are comfortable doing 130/30 because it still has features relevant to benchmarks, so is similar to long only,” he says. “But the risk management becomes much more important in terms of being able to provide that profile to the client. It’s a new trend and many managers are introducing these products but it takes different skills to identify good short positions.” Burton argues, like many early entrants into this field, that manager skill is especially important when one is trusting the manager to get things right in both long and short positions.

One of Axa’s first 130/30 clients in Australia came about because a super fund was only comfortable shorting up to 30%. In fact there’s nothing magical about the 130/30 number: it can be customised to 120/20, 140/40, or any other variation.

These products are beginning to make their way to retail and are likely to do so much more frequently this year. Doing so will require investors to be very clear on what they’re buying, and to understand the risks of leverage. “You are taking more exposure to the market,” says Will Cazalet, director of global long/short strategies at Axa in California. “Leverage carries incremental costs and also incremental exposure to the equity markets. An ability to manage the risk of those increased exposures, particularly on the short side, is critical in a viable retail product.” To put it simply, leverage can magnify gains, and it can magnify losses too.

But do they work? Lately, it would appear so. After the big market falls in January, Mercer Investment Consulting’s David Carruthers remarked that active managers had shown their worth in the volatile markets, and “long/short (130/30 type) funds performed even better, outperforming by 10% over the year.” Carruthers was referring to Australian long/short funds in the Mercer survey, which delivered a median 11.5% in the year to January 31, compared to 1.6% for the S&P/ASX 200. But there are a couple of things to bear in mind in this remark: one, more recent data shows them just as badly hit as everyone else, with a median 11% drop in January alone and a 13.6% decline over three months; and two, this category includes all long/short funds, not just those using 130/30 methods.

“There is some confusion in the industry about terminology,” explains Carruthers. The long-short funds in his survey are not all 130/30, but they do all have a beta of one, which means its net position in terms of market exposure is similar to a long only fund. That’s as distinct from market neutral funds, which can take long and short positions equally and so effectively have a beta of zero.

The Mercer survey considers 13 Australian and three global long/short funds. But some say that, for all the talk, there really haven’t been that many launches in Australia yet. “130/30-type funds are, as far as I can tell, more talked about than in actual evidence yet,” says Phillip Gray at research house Morningstar.

But they’re no doubt on their way. A report by Morningstar out of the USA refers to 33 mutual fund start-ups in this area (which it calls “leveraged net long”) in 2007 alone; managers with 130/30 or similar funds in the US include Invesco, JP Morgan, Mellon, Robeco, DWS, Goldman Sachs, ING, Martingale and Schwab, among others. In total, Morningstar tracks 140 such investment vehicles in its database, including separately managed accounts and collective investment trusts as well as mutual funds. Returns vary widely: an Axa Rosenberg product in the database returned 14.96% to US investors in 2007, while at the other extreme one from Goldman Sachs delivered a 7.66% loss.

Generally, fees on 130/30 products are higher than on mainstream equity products. To take the Acadian product as an example, it can be accessed through a variety of means in Australia, including super funds and investments. Accessed through the First Choice platform, there is a 1.2% management fee, plus a 15% performance fee of returns over the ASX300 Accumulation index (subject to a high watermark, meaning if the fund loses money it has to regain them before any new performance fee can be considered).

It’s worth pointing out that, in theory, a falling or choppy market should be a particularly good time to be allowed to short stocks, since there’s at least as much falling going on as there is rising. It’s also worth pointing out, though, that previous crashes and corrections have not systematically demonstrated that those managers who can short sell do any better in this environment than anyone else.