Welcome back.  Today, we bring you another in our ongoing series featuring the thoughts and perspectives of members of the CAIA (Chartered Alternative Investment Analyst) Association.  You may recognize the name Steve Deutsch from recent media articles on 130/30 investment vehicles.  Deutsch is Morningstar’s resident expert on these vehicles and therefore has a bird’s-eye view of the sector and its recent performance.  Below, Deutsch draws on his company’s extensive database to take a closer look at the 1X0/X0 phenomenon.

ALTERNATIVE VIEWPOINTS (powered by CAIA):
Some perspective on 130/30 funds, a year into the “(r)evolution”

Special to AllAboutAlpha.com by Steve Deutsch, CFA, CAIA, Director of Collective Investment Trusts/Separate Accounts, Morningstar, Inc.

Despite all the excitement about short-extension strategies, 130/30, 120/20 and other constrained ratio investment products are not that monolithic or revolutionary (Morningstar refers to them simply as “leveraged net long”).  Contrary to popular assumption, most are not purely quantitative.  Nor are they the sole domain of mutual fund companies and retail investors.  And given their short histories, many remain unproven.  As a result, it is far too early to determine if these vehicles will reach $2 trillion (or even $1 trillion, for that matter) in the next five years.

Not Monolithic

130/30 is a shared investment strategy, but that’s not a basis for large categorical conclusions.  It’s misleading when money managers or the media make broad general conclusions such as “130/30 strategies did well (or poorly) in the early days of the credit crunch market downturn.”

Sharpe’s law of performance attribution has been cast aside in this discussion.  As always, performance is driven by an investment vehicle’s underlying assets.  In the Morningstar databases we have seen these strategies predominantly invest in ”large blend” assets.  But we also see mid- and small-cap, corporate and government fixed income, and international varieties of these products.  Below are some randomly selected strategies, for both institutional and retail investors, with recent net portfolios presented in a Morningstar ownership zone analysis.  The “centroid” indicates where investments are concentrated, while the ellipse shows the range of holdings in each 130/30 net portfolio.  (Note that the selected money managers actually have very diversified leveraged net long holdings.)

Of course, not all these funds are technically “130/30.”  Every manager has a magic bullet ratio: 125/25, 140/40, or is it 160/60?  In fact, there has been a very limited amount of research supporting 130/30 as the optimal ratio.  This ratio has no doubt been influenced by the limits to shorting available to U.S. 40-Act mutual funds and the enhancements to UCITs in Europe.  Recent research suggesting that 160/60 is the best ratio points to what Bill Gross has observed: that most equity markets are highly efficient and the only way to generate Alpha is to exploit whatever inefficiencies are found with increasingly large amounts of leverage.

Although many varieties exist, 130/30 funds and their brethren should not just be lumped in with Long Short.  Leveraged net long funds are constrained versions of long and short and are not given the same latitude to be variably long and short (and possibly unleveraged) at various points in time.

Unproven: Still Too Early to Make Definite Conclusions

For all its theoretical attraction, there are still not enough long-term track records from actual leveraged net long investment vehicles within asset classes and styles to make conclusions that the strategy has long-term viability and is truly distinct.  And it’s certainly too early to make projections of $1 trillion to $2 trillion in five years.  Long-term performance records, portfolio diversification benefits, and justifiable fees will have to be proven for the typical institutional and individual investor to view 130/30 as the “New Net Long.”

The table below contains the one-year returns, alphas, information ratios, and r-squareds for a limited group of mutual funds and large-blend separate accounts that accept both institutional and retail investors.  For comparison, the unleveraged simple category average for large blend mutual funds is also included in the table.

(Click thumbnail image above to view table)

Note that most funds have positive, although in some cases modest, one-year alphas against the S&P 500.  However, against the Russell 1000, a good benchmark for large blend, the alphas turn negative and the information ratios diminish for a number of the funds.  Using Dow Jones Equity Long/Short Index, all alphas and information ratios are negative.

If this performance keeps up, it seems that the returns of the leveraged net long domestic universe will be normally distributed and not positively skewed (a sought-after trait in these funds).  There could be some outstanding vehicles, some under-performers, and a lot of middling performance.

(Morningstar has been examining the new 130/30 indexes and our initial impression is that they are actively managed selections.  As a result, I did not use them in the above analysis.)

Not a Revolution…More of an Evolution

130/30 or leveraged net long is a natural product development solution to lower than long-term average returns in developed markets.  Some analysts, such as Martin Barnes of BCA Research, have clearly made the case that double-digit equity or fixed-income market returns in developed markets are gone for the next decade.  The conclusion reached by the investment industry seems to be that the only way to get above-average returns at this point in time is to invest in emerging markets and/or commodities, and to do so using leverage in many cases.  Leveraged net long is one of these prodigies.

Research by the Investment Company Institute makes a convincing case that competition equals innovation in the asset management industry.  Money management industry rivalry has led to successive waves of intense development in such areas as socially-conscious funds, index funds, and bear market funds among many others.

In the case of 130/30, a lot of the competition for assets under management has been coming from hedge funds.  In the not-too distant future, traditional fund management companies may move beyond short-selling to another page in the “alternative investment” playbook.   For example, it’s not that far-fetched to assume that some balanced or core funds could evolve into convertible arbitrage mutual funds.

So it’s also not unreasonable to say that “leveraged net long” funds may someday just join the legions of other waves of innovative product introductions.  They may not “burn-out” (like Internet funds), but they may not be a panacea that simultaneously reduces equity exposure and generates alpha.

In fact, 130/30 funds will likely establish a formula that will be repeated in the years ahead for future investment innovations:  Start off in unregistered, less-regulated test-beds like separate accounts and collective trusts.  If the strategy is successful and is worth the cost and time, register the fund as an open and/or closed end mutual fund.  Then simply establish “off-shoots” such as benchmarks, indexes, ETFs, replication vehicles and funds-of-funds.

Not All Quantitative

Despite the common assumption that most leveraged net long funds are quantitative (vs. fundamental), the reality is more complex.  Unfortunately, it’s not that black or white.

In examining the “investment approach” narrative provided to Morningstar by each collective trust/separate account money manager, I perceive four different varieties of leveraged net long investment vehicles:

• Quantitative
• Fundamental
• Quantitative/Fundamental (where the manager appears to be using a mix of both approaches, typically with an emphasis on quantitative)
• Fundamental/Quantitative (where the manager appears to be using a mix of both approaches, typically with an emphasis on fundamental)

You can see the reason for the nuance when you read many of the ambiguous self-reported “investment approaches” contained in our database.  For example, one 130/30 manager indicated to us that their strategy, “is a quantitatively driven, fundamentally based enhancedstrategyWe are very cautious about adding or removing factors unless there is a compelling fundamental reason to do sowe continually re-evaluate the process and improve upon our model”

Not All Mutual Funds or Very “Retail” (Yet)

130/30 began as an institutional offering and remains mainly institutional.  Institutions turned to their consultants, who in turn asked money managers to try and attain alpha by following the tried-and-true alternative investment strategy: short-selling.  This is typically accomplished using investment vehicles that have a high degree of safety rather than a direct investment in a hedge fund (e.g. a separate account).

Of the approximately 140 vehicles using a leveraged net long strategy that Morningstar is currently tracking in our North American and European databases, the majority remain separate accounts and collective trusts.  However, that is changing with rapidly as the following chart indicates.

As you can see, most leveraged net long funds originated in the last year or two.  While the chart would seem to indicate a few with lengthy histories, it is probable that most of the apparent early investment vehicles were actually converted to 130/30 at some interim time.

Leveraged net long funds have not been common amongst most hedge fund firms because these managers don’t have a need (or want) to constrain themselves to a fixed ratio of long and short investments.  If the conditions warrant, they don’t want to be held back by an investment policy statement.

Thus, we have only seen a handful of hedge fund firms offering 130/30 funds so far.  But more are likely to come as assets flow into this strategy.  Anecdotally, I have run across several hedge funds considering these funds at various 130/30 conferences at which I’ve been asked to speak.

Conclusion: 130/30 as a “convergence” strategy

The money management industry seems to be borrowing an idea from the telecom and communications industries - that various developments will eventually “converge” toward one offering.  But it may still be premature to conclude that convergence will be successful. And ultimately, this convergence could end up reminiscent of insignificant and ultimately unsuccessful technologies such as ”WebTV.”  But we are certainly witnessing the traditional meeting the alternative in a number of areas…

Hedge funds in search of permanent capital are being acquired by firms that want to expand their capabilities.  In late October, for example, Citigroup acquired Carlton Hill Global Capital and a similar, larger transaction occurred earlier in the year of Old Lane Partners.  In addition, Wall Street, Bay Street, and firms in The City are making their “architecture” open by providing investors with more access to outside and alternative-oriented money managers.

Likewise, we now see alternative strategies offered in traditional investment vehicles such as leveraged net long funds.  The adoption of alternative strategies by collective trusts, separate accounts, open and closed end mutual funds, and (most recently) ETFs are therefore a sign of the times.

- S. Deutsch, December 31, 2007

Note: The opinions expressed in this guest posting are those of the author and not necessarily those of AllAboutAlpha.com.