Alternative Investment Management Association
Fortis Prime Fund Solutions
Commentators on the alternative and traditional asset management industries are predicting an explosion in the demand for so-called 130/30 funds in the coming months and years. So what are they and what opportunities and threats do they present? Will these products provide the impetus for investors who were hitherto not invested in alternatives, to begin to make significant allocations to hedge fund type strategies? Could these products eventually prove to be a substitute for hedge funds?
What are 130/30 funds?
130/30 funds are similar to long-only funds to the extent that they build a portfolio as normal, allocating 100% of NAV to long positions. They differ, however, from traditional long-only portfolios to the extent that they then short sell securities to the value of 30% of NAV. The proceeds from the short sale are then used to acquire additional long positions, thereby bringing the total exposure to 130% long and 30% short. The 130/30 product provides market exposure or “beta” but also enables the fund to generate additional “alpha”.
One other fundamental area of difference between 130/30 funds and traditional long-only funds is in relation to the fees charged by 130/30 funds. In a recent report, Merrill Lynch indicate that fees charged by 130/30 funds are higher than those typically charged by long-only funds. Where a typical US long-only manager will charge 30-50 basis points management fee, a 130/30 can typically charge 60-100 basis points. To date, there is no evidence to suggest that even fundamental 130/30 managers will be able to charge performance fees along the lines of those charged by hedge funds.
Who is launching these products and where is the demand coming from?
It is estimated that the industry is in the region of $50bn - $60bn and, it would seem, is growing at a significant rate. The current demand is coming from pension funds and, to a lesser extent, other institutions. It is likely, however, that these products will become increasingly appealing to retail investors in future, particularly given that they can be offered within a UCITS structure. The common interpretation of UCITS rules is that they cannot short sell in a physical manner. However, under UCITS III, they are permitted to short through the use of synthetic instruments, such as options and contracts for difference. Now that funds established under UCITS III rules are afforded the opportunity to go short, thereby creating an opportunity for asset managers to devise more creative fund products, there is a clear pan-European target investor base for the 130/30 fund. State Street Global Advisors have recently been appointed to manage a £165m Global Equity 130/30 mandate (a UCITS compliant 130/30 product) by the Asda Group’s Pension Fund. The California Public Employee Retirement System plans to incorporate 130/30 strategies into its $53 billion international fixed-income portfolio.
Fund of funds managers too, rather than seeing these products as a threat, could actually embrace the 130/30 funds, with UBS having already launched a fund of 130/30 funds.
According to Pensions & Investments, Russ Kamp, chief executive of the global structure products group at INVESCO’s New York office, estimates that 20% of the money invested in US large-cap long-only strategies will move to short-enabled strategies over the next 10 years.
Other entities which have launched 130/30 funds include Fortis Investments, Axa Rosenberg and BGI, to name but a few.
What strategies are 130/30 managers running?
It appears that the existing funds are mainly running quantitative strategies and Pensions & Investments estimate that as much as 80% of these assets are in quant strategies and 20% are in fundamental long/short equity strategies. Pensions and Investments also state that JP Morgan is one of the main fundamental managers winning 130/30 mandates, running a total of $1.5bn in two different strategies.
Winners and losers
Clearly several groups are set to benefit from the proliferation of 130/30 products. Of course, assuming these products realise their potential, prime brokers will undoubtedly benefit from this new asset class, given that it opens a whole new market of possibly enormous size. According to Financial News, Credit Suisse, Deutsche Bank, Goldman Sachs, Lehman Brothers, Morgan Stanley and UBS are all pursuing 130/30 mandates and no doubt competition for new mandates will be fierce.
There is a challenge of how these products can be best serviced by administrators. From the point of view of valuing these funds, it would seem that hedge fund administrators are best placed to provide this service. On the shareholder servicing side, however, as these funds begin to attract retail investors in large numbers, it is likely that traditional long-only managers will be better equipped to handle the shareholder servicing side of this business.
Existing investors in long-only funds stand to benefit through access to products which might not only be better able to manage their downside risks but potentially also offer investors better performance.
Long-only managers are undoubtedly witnessing that their investors are beginning to allocate, or are increasing their allocations, to hedge funds and this trend is set to continue. In this environment, the introduction of a product which incorporates a mechanism for generating alpha has got to be an appealing proposition for investors. There is, however, a real danger that managers with little or no experience in shorting will bring products to the market which underperform the market and not only fail to deliver alpha but also have a negative impact on the managers’ ability to produce beta. Of course, managers hitherto, purporting to be hedge fund managers due to their shorting capabilities (albeit that shorting may be used in an extremely limited fashion), could come under real pressure in an environment where 130/30 funds are producing comparable risk adjusted returns. Established hedge fund managers are not likely to suffer any major fallout from the proliferation of the 130/30 product and so long as they are demonstrating consistent superior performance, their products will continue to attract investors and performance fees and should not come under pressure.