Money managers and prime brokers love 130/30 strategies. If you want to know why, just follow the money.
While a pension fund typically pays 50 to 75 basis points for an active U.S. large-cap strategy, it pays about 25 basis points more for a 130/30 strategy.
Many firms are converting existing active U.S. large-cap equity accounts into these strategies, which permit the manager to make bigger bets on stocks they expect to go up by leveraging their portfolios by 30% and shorting potential losers by an equal amount. The net effect is that the portfolios have a 100% exposure to the stock market.
“Money managers are pushing this because they would like to have less constraints, but also because there’s a higher fee charged in these accounts,” said Paul von Steenburg, a vice president at consulting firm Wilshire Associates Inc., Santa Monica, Calif.
For prime brokers, 130/30 gives them access to a whole new area of revenue. Most pension funds and traditional managers do not have relationships with prime brokers, which service and finance these portfolios. The prime brokers’ typical take: about 50 basis points, picked up from the spread on leveraging portfolios and lending securities. That fee can increase if stocks are difficult to borrow.
In the space of two to three years, 130/30 products — also known as active extension or short-extension strategies — have pulled in an estimated $30 billion to $60 billion in assets around the globe. (Some strategies use different ratios, such as 120/20 or 140/40, but the principle is that they all have full market exposure.)
$1 trillion?
If industry sources are correct, this is just the tip of the iceberg.
Charlie Shaffer, a managing director for multiproduct marketing and the 130/30 product manager for Merrill Lynch Global Markets Financing & Services, New York, estimates there could be anywhere from $500 billion to $1 trillion in active extension strategies by 2010.
“With the heightened interest by plans, consultants and managers, seeing 130/30 investments increase tenfold in two and a half years is not difficult to imagine and would yield a meaningful amount of assets,” he said.
Churchill G. Franklin, executive vice president of Acadian Asset Management Inc., Boston, thinks 130/30 strategies will hit at least $300 billion within the next 18 months. “In fact, I think this is a conservative estimate,” he said. Acadian managed $1.5 billion in short-extension strategies as of March 31.
Institutional investors everywhere are trying to boost alpha in an era of low expected returns. While they are looking to alternative investments such as hedge funds and private equities for some of this alpha, most institutions make relatively small allocations to these asset classes. However, 41.1% of corporate plan assets and 44.1% of public plan assets are in domestic equity, mostly large cap, and 130/30 is being predominantly used as a substitute for domestic large-cap equity.
“Ultimately, we think these strategies are a better way, relative to long-only, for investors to run their active equity portfolios. By moving to 130/30 strategies, investors have the opportunity to seek more alpha without having to do any kind of massive reshaping of their asset allocation or portfolio structure. In essence, all they need to do is loosen their guidelines for active equity managers,” said Adam L. Berger, vice president of AQR Capital Management LLC, Greenwich, Conn. AQR had $750 million in quantitatively managed, short-extension U.S. large-cap and global equity strategies as of March 31 and has seeded a U.S. small-cap strategy.
In this environment, U.S. large-cap managers are seeing assets race out the door. Active U.S. large-cap core equity managers saw outflows of $12.8 billion in 2006 and $1.6 billion in 2005, according to reports from Casey, Quirk & Associates, Darien, Conn.
Nor do hedge fund managers want to miss a piece of this lucrative new business. Maverick Capital Ltd., New York, had $10 billion in fundamentally managed long-only, hedge fund and 130/30 strategies, with $110 million in 130/30 alone, as of March 31.
“There is a lot of interest, but it’s not clear yet whether this is the latest fad or a new investment paradigm. I’m inclined to think it’s the latter,” said Lee Ainslie, managing partner.
‘Smoke and mirrors’
But experts warn 130/30 strategies are no panacea.
“We’re always skeptical of product launches with this much hype,” said Greg Dowling, vice president of alternative investments for consultant Fund Evaluation Group, Cincinnati. “We’re a little skeptical of the amount of push and the number of entrants in the marketplace.”
There are 85 managers in various stages of rolling out short-extension strategies, but only one-third of them have received external funding, according to a presentation made by Florian Weber, a research analyst in Wilshire Associates’ manager research group, at the Corporate Funds Symposium in New York May 14.
Consultants such as Mr. Dowling believe that allowing a money manager to go short in a portfolio can help institutional investors add more alpha. They say 130/30 strategies are an innovative way for pension clients to get access to the benefits of shorting without having to sell their board of trustees on hedge funds.
But Mr. Dowling doubts whether every manager will be successful at shorting. “You’re going to have 20% of managers that are good at this and have the ability (to short stocks well.) The other 80% are part of the ‘me too,’ ” Mr. Dowling said.
Some managers are critical of their own peers that are introducing 130/30s. “Part of the smoke and mirrors of the whole 130/30 approach is that it’s a more leveraged approach to managing money,” said Ted Aronson, a partner at Aronson + Johnson + Ortiz LP, Philadelphia. “But if you don’t have alpha, your leveraged situation isn’t going to give it to you.”
In some cases, a pension fund could benefit more from investing in a market-neutral hedge fund and combining that with a Standard & Poor’s 500 swap or futures contract to gain market exposure, Mr. Aronson said.
“Why not get exposure to the market for a very low fee through any index fund manager, then go all the way to the extreme and combine it with the wildest alpha-generating manager you can find?” he asked.
Mr. Aronson’s firm manages $2 billion in short-extension strategies. “I like 130/30. I’m not against it, but there’s nothing magic to it. It’s not voodoo,” he said. But, he added, pension funds should consider the cost of the 130/30 strategy and the amount of alpha they will get.
Other managers also warn against a strong push. “My only concern is that clients may be giving the benefit of the doubt to managers who may not have the skill set” to short, said Russell Kamp, chief executive officer of the global structured products group in INVESCO’s New York office. Those managers “are trying to play offense as opposed to defense because they could be subject to assets being taken away.”
Prime brokers’ roadshows
For prime brokers, 130/30 strategies offer a pot of gold at the end of the rainbow.
Many pension fund officials find they need a prime broker for the first time when they decide to hire 130/30 managers. That could be the beginning of a beautiful friendship.
“In a market with hot competition for hedge fund market share, pensions are brand new” to prime brokers, said Barry Bausano, co-head of global prime finance for Deutsche Bank Securities Inc., New York.
The amounts that potentially could pour into 130/30 strategies could eventually dwarf those flowing into hedge funds. Hedge funds make up just 1.9% of the $6.5 trillion under management by U.S. institutions, according to an April 2006 study from Greenwich Associates, Greenwich, Conn. That’s because institutional investors generally make a smaller allocation to alternative investments, which include hedge funds, than to U.S. large-cap stocks.
If pension executives invest in a 130/30 strategy as a separate account, which is typically the case, instead of a commingled fund, they choose the prime broker.
And 90% of the time, that prime broker ends up servicing all of the short-extension strategies in which the pension fund invests in the future, said Sarah Barratt Ball, executive director for Morgan Stanley Prime Brokerage, New York. “It’s a chance for new investor relationships, which we value highly, but also a conduit to relationships with new managers,” she said of 130/30s.
Those new relationships with long-only managers are as important to prime brokers as their new relationships with pension funds, prime brokers say. If the prime broker can form a good relationship with the manager as they service their 130/30 strategy, the hope is that the same manager will turn to that prime broker when they launch alternative products that use shorting or leverage.
“When we see a manager launch a 130/30, it’s a signal to us they’re thinking about launching a broader set of alternative products that we can partner with them on,” said Regina Gannon, managing director and head of the equity client relationship management group for UBS Investment Bank, New York.
As a result, prime brokers are actively marketing 130/30 strategies. Prime brokerage firms including Merrill Lynch, Morgan Stanley, Deutsche Bank, UBS and Lehman Brothers Inc., New York, are conducting educational road shows, teaching pension fund executives about the potential benefits of 130/30 and also some of the administrative and operational complexities that come with shorting in such strategies. Many of the road shows are conducted alongside managers that already have 130/30 strategies.
Each prime brokerage firm is conducting its marketing efforts in an attempt to establish itself as a lead player before more assets flow into 130/30 strategies.
“The prime brokerage business is already growing significantly from hedge funds, but the size of assets related to 130/30 has caused an enormous sea change,” Morgan Stanley’s Ms. Barratt Ball said.
