True Long/Short vs. 130/30: Alpha + Lower Vol vs. Beta + Higher Vol

I’m a long/short bull and a 130/30 bear. Why? Long/short investing gives managers the best opportunity to generate alpha and manage volatility without being constrained by an index. 130/30 funds, conversely, place artificial parameters around both gross and net exposure and lack the intellectual purity of their more flexible long/short cousins. There were two stories in today’s Financial Times that highlighted each of my deeply-held views; this must be a gift in anticipation of my blogiversary tomorrow.

First, the power of long/short investing:

For the year to date it is one of the best-performing strategies, with
a return of 9.25 per cent, according to figures from Credit Suisse
Tremont. This is ahead of the 7.86 per cent average return for hedge
funds across all strategies and beats the 6 per cent year-to-date
return on the S&P 500 index.

Long/short managers are therefore among the few groups in the hedge
fund industry, alongside event-driven and multi-strategy managers, who
can make a convincing case that their often hefty performance fees are
justified.

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It is a widely held belief among a broad range of investors that most
port-folios should maintain a long-term weighting of between 40 and 60
per cent in equities. But a glance at historical figures shows equity
long/short produces superior risk-adjusted returns in comparison with
long-only equity in both bull and bear markets. The ABS study attempts
to analyse the reasons for this out-performance.

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One of the potential advantages of equity long/short investing is
that it provides active management. According to ABS, the
differentiation between active managers such as hedge funds and
semi-passive managers - including mutual funds and long-only accounts -
has been one of the main factors driving hedge fund growth.

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A study last year by Martin Cremers and Antti Petajisto of Yale
School of Management shows equity mutual funds that closely track an
index significantly underperform those that provide more active
management. Laurence Russian, principal of ABS, said this argument
could be extended to hedge funds because the vast majority of equity
long/short funds do not manage to an index.

Therefore, the
ability of hedge funds to provide active management should result in
higher risk-adjusted returns and fewer drawdowns over long time
horizons, in spite of their higher fees.

Mr Russian added that
flexible portfolio management is another factor allowing long/short
portfolios to generate superior risk-adjusted returns. The equity
long/short strategy gives investors access to both amplified alpha and
flexible beta. Alpha is defined as the excess return over the benchmark
as a result of stock selection after stripping out the portion of the
return attributed to beta, or market exposure.

Flexible portfolio
management and its advantages manifest themselves primarily in periods
of negative returns or increased volatility. The ability to shift
exposure and change from aggressive to defensive stocks allows fund
investors to capture the upside of an upward-trending market while
protecting capital in down periods.

Next, some questions arising from the proliferation of 130/30 funds:

Rodney Williams, managing director of Feri Fund Market Information, put
the cat among the pigeons when he linked the hype surrounding absolute
return funds in Monaco in 2004 with that building around 130/30 this
time around.

The observation hit home in some quarters with Mark Tennant, a senior
adviser at JPMorgan Securities, opining: “There are probably 10 or 12
asset managers in the world with the investment management and risk management skill-sets to manage 130/30 funds.”

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The rationale for 130/30-type funds is compelling. Long-only managers
can only underweight, not short, stocks they do not like. While this
may be fine for large-cap stocks and low tracking error funds, it is
problematic for smaller stocks and punchier funds.

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With information ratios (excess return divided by tracking error) of
about 3 before fees, these portfolios have outperformed their
respective long-only strategies, albeit with higher volatility. “They
are doing what it says on the tin; higher volatility and higher
return,” says Alistair Sayer, investment director, multi-strategy
equities at Henderson.

In spite of these arguments, doubts
remain. Todd Ruppert, chief executive of T Rowe Price Global Investment
Services, warns: “I think there’s going to be a lot of blood on the
tracks with 130/30 products.

“The view that 130/30 funds will
generate a better information ratio presupposes that you have the
skills to do it. Most long-only managers don’t outperform the market,
and that is where their expertise is, and now you are going to let them
short.”

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Watson Wyatt’s Mr Baker argues that if investors have accepted the
value of shorting, it is illogical to then restrict themselves to “beta
1” products, although he does accept that 130/30-type offerings can
have less onerous fee structures than more traditional long/short
funds. “They are hedge funds, and clients need to be aware of that,” he
says. “Being prepared to relax the short constraint and introduce
leverage opens up a world of possibilities, but it doesn’t really make
sense to limit yourself to a beta of one and 160 per cent gross
exposure.”

Sometimes even mainstream media can hit the nail on the head. And it is nice to get some validation now and again.

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COMMENT:

AUTHOR: Yaser Anwar

EMAIL: yaser@yaseranwar.com

URL: http://www.yaseranwar.com

DATE: 07/17/2007 03:30:55 PM

On a gross basis, the investor in 130/30 has $1.6 exposure to the HFM’s strategy for every $1 invested. This works to the investorís advantage if the HFM is truly skillful, but the addition of leverage can expose a beta driven strategy very quickly, because leverage will amplify losses when that beta exposure is out of favor. Short positions in a 130/30 strategy are not necessarily hedges against losses on the long side.

The majority of 130/30 managers donít have long track records. Money is being moved from existing accounts to these approaches because institutional investors “feel” moving from a traditionally managed account into an unconstrained version would add alpha to their portfolios.

Like you mentioned sir, the best approach, or a better one anyway, is to not have constrained parameters for having net exposure, be it long or short. IMO, several traditional long-only managers are quite capable of moving into the long/short space. 

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COMMENT:

AUTHOR: Shane Hoover

EMAIL: shane.b.hoover@gmail.com

URL: 

DATE: 07/23/2007 10:21:45 AM

You probably have already seen this on your radar but Man Group is planning a closed end fund to be offered in the US that will pair a L/S (Thyke) manager with its flagship managed futures fund AHL. This would provide an investment vehicle more akin to those they currently offer to individuals internationally.

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3 years ago | view comments |  Hedge Funds