Testing times
The rationale for 130/30 funds is seductive. The idea is you get a lot more return for just a little more risk, but since their launch they have been attacked for being neither fish nor fowl – indeed, the most popular criticism is that they offer the “worst of both worlds”.
2007 provided an opportunity to see how this relatively new concept would stand up to adverse conditions – and the quant models found it rough riding. By contrast, their fundamental counterparts were able to adapt to the tougher macro environment more easily.
Generalisation in this market is difficult, but broadly speaking, 130/30 quant funds use a mechanistic ranking process based on the computation of historical data; have full market coverage; benefit from market breadth; and take a large number of small bets. They also rely on back-testing – but there is no testing like live market testing.
Their fundamental equivalents rely on a qualitative investment decision process; concentrate on their top conviction ideas; can benefit from skewed indices; and take a small number of large bets. Fundamental manager Peter Lees, head of UK equities at F&C, argues that quant 130/30 is wasteful and dilutive in that a common approach is to replicate the entire index first and then add 30 pct of longs and 30 pct of shorts.
“If you recreate the index first then you are not putting on a proper short, because it is still represented in that initial 100 pct,” he says. “Also, you are reproducing the long and wasting capital.”
He adds that as the FTSE All-Share is a very concentrated index, managers are effectively shorting the bigger stocks by not owning them. “The top 15 companies make up nearly 50 pct of the benchmark and about 75 pct of the index is made up of only 50 companies.” Beyond this there is a long tail of tiddlers. “The question is how many positions do you need to take to get a full diversified portfolio whilst keeping volatility to an acceptable level?”
Mark Webster, senior investment manager at SSgA, one of the leading quant 130/30 managers, says that SSgA’s approach does vary from market to market depending on the target audience and whether derivatives are allowed. “In some countries there is stamp duty and you can avoid paying this by using derivatives. This is particularly the case in the UK market, where we use a single swap. We go long 130 pct and short 30 pct and it’s all considered one investment, relating to the underlying holding.”
He argues that fundamental managers have a process that tends to only identify the very best stocks, rather than ranking all the stocks in an index and gaining from the spread between best and worst, like a quant manager. “The quant approach typically involves looking at different characteristics of stocks and ranking companies from top to bottom within their sectors. We do this across all sectors in the index and then pick the top 20 pct ranked companies, plus some from lower down in the rankings for portfolio diversification reasons to reduce the risk,” he explains.
“But the reason why 130/30 is better than long-only is because it allows us to identify the worst companies in the index and go short. Many of these companies have small index weightings so in a long-only fund you would not be able to take a proper position on the negative side. With this approach we get an extra spread between the best and the worst, by shorting the stocks we don’t like.”
Webster stresses that SSgA operates on an industry neutral basis – it doesn’t take big weights in sectors or big deviations away from the benchmark. 2007 produced such a broad range of returns because those houses that called the sectors right – for example, going heavily underweight financials, and heavily overweight tobacco stocks – gained disproportionately due to the magnitude of the moves. “So there have been some houses who may have done nothing for years who have done quite well.”
Conversely, quant managers had a difficult year, partly due to the M&A cycle, and partly due to the credit crunch: “There was a lot of venture capital money that was coming in and they weren’t really paying much attention to valuation metrics because of the cheap financing that was available,” he says. “The other problem relates to when you have a big change in expectations but not a big change in reality.”
Webster explains that August’s credit crunch triggered a change in the perception of how the economic cycle was going to turn out which meant that stocks were sold indiscriminately, hurting those with systematic models. However, a rapid change in expectations will be followed by a slight lag as accounting data and other inputs catch up. “It will take a little while for analysts to update their forecasts. The benefit with a quantitative model is when you get a change in expectations but nothing follows through. Whilst you might underperform for a month, if you don’t do anything radical with your portfolio you avoid a lot of false dawns.”
Given that quant funds struggled in 2007, and higher market volatility looks set to stay, how might this strategy develop? Andrew Barber, global head of manager research at Mercer, says that 130/30 has attracted a lot of interest in the UK and Europe but it has been more successful in pulling in funds in Australia, Japan and the US. Meanwhile, more fundamental managers are waiting in the wings.
“There are some 130/30 products in the UK but they are not huge in volume,” he says. “I think a lot of fund managers are running paper 130/30 strategies or live ones with small amounts of seed capital to see if they can short successfully. In a year or so, maybe those that have worked will come out of the woodwork, and those that don’t will die a death. But then you have to be wary because the ones that reach the market will represent survivorship bias.”
As well as traditional fund managers, there is also the possibility that more hedge funds will come into this space in an attempt to reduce their volatile earnings streams. “Hedge funds are very opaque and haven’t performed well recently – they are now 95 pct correlated with the S&P because there are too many of them and not enough diverse strategies,” asserts F&C’s Lees. “They know how to short but they don’t know institutional investors, so it is possible they will offer high alpha, scaleable 130/30 strategies to attract institutions and get the volatility of their earnings under control.”
Barber strikes a note of caution, however: “Some hedge funds are interested in institutional money, but they will want higher fees than the traditional managers offering 130/30. Also, you’ve got to question their motivation for doing it,” he points out. “How much money can they really manage without their dealing costs getting in the way? And if they’re trying to get into 130/30 products does that mean they can’t sell their long/short products because they’re not good enough? Why would they want to eat up capacity in a lower margin product?”
If you want to read more about how quant 130/30 managers are revising their models in the light of 2007’s performance, please go to:
