It’s shaping up to be a banner week for alpha-centric investing in Europe.  No sooner had the ink dried on one landmark alpha-centric mandate (see yesterday’s posting about a $3b European 130/30 mandate), when another major European institution announced it would dump some of its funds of hedge funds and place its bets on “alternative beta” (a.k.a. hedge fund replication) instead.

One of Sweden’s public pension plans, the EUR9 billion AP7, announced the news at a conference yesterday.  Reports IPE.com:

“Richard Grottheim, executive vice president of AP7, told delegates at the Pension Fund Investment World Nordic 2008 conference in Stockholm today the SEK 80bn (EUR8.6bn) fund had already reduced its allocation to hedge funds from 4% to 2% in 2007 because of ‘disappointing returns’ in the market.”

Grottheim told the gathering that he could get “the same returns” by investing directly in the risk factors that tended to drive hedge fund returns. (see previous posting on AP7’s alpha/beta separation programme)

But is this really the primary motivation for the move?  Since hedge fund of funds returns are reported net of fees, it appears as though AP7 won’t be any better off after the shift.  Granted, they won’t have to deal with the discomfort of making any fund of hedge fund managers rich (while they simultaneously aim to fund the retirements of hard working Swedes).  But how does this shift really make life easier for the pension plan?

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Apparently, 130/30 isn’t going away anytime soon.  Another survey of institutional investors released this month says that over half (51%) of public pension plans “are using, seriously considering, or evaluating” 130/30 strategies.  The number was significantly less for corporate plans (31.5%) – a phenomenon uncovered by some previous surveys as well.  On its own “considering” doesn’t mean a lot.  After all, a lot of people “considered” – and subsequently dismissed – the idea of buying ”New Coke” back in the 80’s.

So is 130/30 the New Coke of asset management?  Will we eventually pine for the “classic” version of our favorite active managers?  This survey, for one, suggests not - only 14% of pensions thought 130/30 was a “passing trend”.

This is another in a growing body of surveys on 130/30 (of which our 2007 survey with Terrapinn is a part).  So we thought this might be a good time for a re-cap.  Below is a quick list of all the 130/30 industry surveys we can immediately recall (in chronological order).  If we have missed any, please let us know.

2006

• Survey sponsor: Pyramis Global Advisors (Link to source)
• Survey conducted: October/November 2006
• Sample: 214 US public and corporate defined benefit pension plans with assets over $200 million
• Findings:
  7% using 130/30 strategies
  51% seriously considering 130/30 strategies

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Doug Kass of Seabreeze Investment Management, a veteran short manager and market commentator sure isn’t sold on 130/30.   The manager of $200 million of short positions tells Barron’s this week:

“These funds are a silly gimmick and their half-life will be short. Nearly every long/short manager thinks he is equally facile on the short side as the long. Shorting requires a different skill set; you have to have the mindset of an investigative reporter and be a skeptic at the core. Also, many 130-30 funds use exchange-traded funds [ETFs] as a proxy to short. That’s a cop-out and a poor way to produce excess returns.”

There’s no question shorting requires “a different skill set”.  But like any skill-set, these skills can be bought and sold by participants in the asset management industry – enabling long/short managers and even (gasp!) long-only managers to rapidly move onto a level playing field with seasoned short-sellers.  Unless you consider some kind of inherent culture that makes for successful shorting, no asset manager can hope to erect barriers to entry in this burgeoning niche.  In our view, it’s just not that fundamentally unique when compared to long-only or long-short.

Long-only managers have been immigrating to the Republic of 130/30 for some time.  Now the republic’s other border (the one it shares with Hedgistan) is also experiencing an increase in traffic.  Italy’s Banca Fideuram handed over a whopping $3 billion mandate to hedge fund behemoth GLG recently.  As HedgeWorld reports this week, the bank says: More…

Whether one is referring to a 1X0/X0 fund or to some other long/short variant like a market neutral fund, there is often an implicit assumption that the “net exposure” provides all the insight required into the return potential of the fund.  For example, many commonly assume that 130/30 funds are “beta neutral” and therefore that the “30/30″ portion will generate pure alpha.  But what if that short-extension was just offsetting?  To use an extreme example, if it was 30% long the S&P and 30% short the S&P, then there would be no alpha.

A research paper by Morgan Stanley (available here at AllAboutAlpha.com with free registration) reminds us that dollar-weighted exposure is not synonymous with beta-weighted net exposure.  But the paper, another in a series by Marty Leibowitz and Anthony Bova, also argues that the beta-weighted net exposure doesn’t really tell us a lot about the potential information ratio (alpha/tracking error) of the fund.  To gauge the potential IR of a fund, one should instead look at the ratio of “active” long positions to “active” short positions – or what Leibowitz and Bova call the “active ratio”.

The active ratio, they argue, is more descriptive of the risk/return dynamics of a fund than the more recognized dollar-weighted or beta-weighted net exposure.  They say the Active Ratio can reveal how long/short funds and 130/30 funds are really just first cousins:

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Last year, we published a couple of articles on the somewhat Malthusian possibility of a global shortage of stocks available for borrowing. (“A Shortage of Shorts?”, “The Arms Merchants of 130/30“, “Is There a Capacity Constraint Facing 130/30 Strategies?”).

Although the 130/30 market has grown since then, it remains in the very low hundreds of billions globally.  Yet in a report released a few days ago, the Security Traders Association (STA) blames recent market volatility, in part, on 130/30 funds.  Says the report:

“There has also been a significant increase in the number and impact of 130/30 funds, used by both traditional mutual fund and hedge fund managers.  That said, all of these funds have at least two common denominators: they seek to raise new capital, and they seek robust returns. In fact their enhanced returns allow them to raise more capital. In order to earn the returns needed, they may deploy investment and trading strategies aimed at short-term performance. This trading behavior (with a focus on a short-term window of opportunity) in itself creates movement and momentum among stocks that fuels volatility and velocity.”

High velocity hedge funds seem to be primary focus of the STAs concern.  But 130/30 isn’t the only institutional investment strategy at which the STA points a finger.  The use of derivatives (for example, for portable alpha) is also identified as a growing source of market volatility by the report:

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Regular readers may remember our survey of attitudes toward 130/30 funds last August.  Since that survey, several others (e.g. Merrill Lynch, Vodia Group) have come up with similar numbers – about 15-17% of institutions actively investing in 130/30 and another 25-30% considering investments in the next 12 months.  Today, Kathryn Wilkens tells us of a recent survey of practitioners (members of the Chartered Alternative Investment Analyst Association) on this topic in our regular installment of “Alternative Viewpoints”.

A true advocate of alternative investments herself, Kathryn Wilkens received a Ph.D. in finance at the University of Massachusetts in 1998, and received a Center for International Securities and Derivatives Markets (CISDM) fellowship in 1997.  She was on the CAIAA’s advisory board from the program’s inception in 2002 though 2005, and is now the CAIAA’s Director of Curriculum.

Alternative Viewpoints – powered by CAIA

Special to AllAboutAlpha.com by: Kathryn Wilkens, Ph.D., CAIA

Last month, 440 CAIA members responded to a survey on 130/30 funds and I presented the results at Terrapinn’s 130/30 conference in Santa Monica.  The survey questions were structured around two main themes frequently discussed here at AllAboutAlpha.com:

• What is the most appropriate benchmark for 130/30 funds?
• What best describes your opinion about 130/30 funds?

When I posed the first question to the attendees at the Terrapinn conference, all but one responded that a standard long-only equity index such as the S&P 500 index or the Russell 2000 is the appropriate benchmark for 130/30 funds.  Yet Dow Jones, Credit Suisse, and S&P have all recently developed 130/30 indices (see related AAA postings Dow Jones joins the 130/30 Index Parade, S&P follows CS into 130/30 index business, 130/30 Indices: True indices or like playing chess against a computer?)  Two of these indices are classified as a type of Strategy Index with another being a so-called fundamental index.

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Last September, we noted that hedge funds in South Africa and several other off-the-beaten-path places seemed to be holding up okay through the August storm.  Now with gold prices flirting with all time highs, South African managers (hedge and long-only) seem to be attracting a lot of renewed interest.  The April edition of Institutional Investor magazine shines a light on South Africa.  Next week, Terrapinn will be hosting an “Alpha Beta Summit” in Cape Town.  And last month HedgeWeek published a special report on the country’s hedge fund industry.  HedgeWeek observed in an article published alongside the report that since March 2004, the South African hedge fund index had grown by nearly 20% per annum (vs. 12% for the MSCI World).

But is it really alpha?   To address this question for us, we welcome the following guest contribution from Helena Conradie of major South African money manager Sanlam Investment Management.  Helena is the Head of Sanlam Investment Management’s equity quant boutique that manages over R21 billion.  She is a CFA charterholder and has an MSc in Applied Mathematics Cum Laude from Stellenbosch University.

Special to AllAboutAlpha.com by: Helena Conradie, SIM Equity Quants

In just more than 18 months people all over the world will flock to South Africa to attend the world cup soccer event, paying generously to see amazing flair and display of talent. But would they consider South Africa as the location for amazing alpha?

At any given time there is a finite amount of alpha available for fund managers to hunt.  And as we all know, it is “all about alpha!” The diversity of stock returns across all sectors (the cross-sectional volatility) is a good indication of the presence of alpha.  So does the South African rainbow provide the alpha hunter with enough diversity?

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Back in November S&P launched its 130/30 Index, a new yardstick for short-extension funds.  To create the index they added a short extension to their existing proprietary stock-selection model and chose their words carefully when describing the result…

“The S&P 500 130/30 Strategy Index is designed to measure the performance of an investment strategy that establishes over- and underweight positions relative to the S&P 500, its parent index.”

We were skeptical – noting that 130/30 amounted to simply leveraging the alpha potential of a strategy and was not really a strategy on its own (see posting).  But we didn’t confine our skepticism to S&P.  We also raised questions about the approach taken by Credit Suisse (see posting).  We reasoned that since both indices were based on proprietary models, their performance was entirely contingent on the performance of each company’s underlying investment decisions.

While S&P stopped short of saying its index was “representative” of 130/30 funds, a published index like this is obviously meant to be used as some kind of benchmark for 130/30 managers.

But now another S&P report says the best benchmark for 130/30 managers is actually an appropriate long-only index…

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In a quick addendum to yesterday’s posting on the growth of fundamental 130/30 strategies, here is an example of one company that aims to distance itself from the pure 130/30 quants by adding an “intuitive” element to quantitative decision making.

BNY Mellon Asset Management launched a 130/30 fund for European investors a couple of weeks ago that it says attempts to “harness alpha in a slightly different way than other quantitative managers by placing emphasis on fundamentals and economic intuition, rather than depending on more empirical methods.”

While it’s not quite a slam against more quantitative fund, it does reflect the unease asset management marketing departments have with the association 130/30 has developed with one of last year’s sorriest alternative strategies.

Pensions & Investments reports that assets in US 130/30 strategies grew 22% over the past 2 quarters.  While still an annualized growth rate of close to 50%, the newspaper points out that this is a slower growth rate than the 77% experienced in the previous 2 quarters.

While P&I describes this growth as “drastically slower” than last year, the numbers are still relatively small (53 managers), so it’s tough to draw any definite conclusions from these numbers.  But we were were struck by what P&I said next: “…with most asset gains picked up by fundamental managers…”

While fundamental strategies are gaining, quants still continue to dominate 130/30-land.  As we’ve suggested before, it’s difficult to disentangle the poor performance of quant strategies in general from the performance of 130/30 as an investment approach.  A rise or fall in 130/30 assets says more about managers’ view of the potential returns from beta, their own skill-level, their clients’ demands and their own particular business model than it does about the merits of short extensions per se.  As a half-way point between long-only and market neutral funds, short extensions are simply an more aggresive form of active management, not an exotic new approach to investing.

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As the footnote to Chuck Jaffe’s recent MarketWatch piece on 130/30 suggests, his opinion carries a lot of weight (“His work appears in dozens of US newspapers”).  So when he presented such a negative view of short-extension strategies, we felt compelled to explore his arguments further.  Unfortunately, while he presents an adequate understanding of the strategy, he is too quick to write off the approach.

His April 20th commentary is entitled “Long on shortcomings: Numbers don’t add up for faddish 130/30 funds” and his main argument is that “early returns don’t seem to justify the hype”. While that may indeed be the case, extrapolating from these early returns is premature at best and totally inappropriate at worst.

Headline-writers as “dozens of US newspapers” are getting creative with Jaffe’s piece:

• “As the latest fad in funds, 130/30 is looking overblown”
• “Fidelity follows dubious fad by opening 130/30 fund”
• “Look beyond hype of trendy plans like 130/30 fund”

Stretching the data

Unfortunately, readers in dozens of US cities are now getting the wrong idea about 130/30 funds.

For example, Jaffe references research conducted by the UK-based Investment Week magazine:

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Faced with a lack of track record for active extension funds, researchers are forced to re-create how these funds would have performed if they had existed for some time.  The idea is to select an “alpha model” (an unfortunate term since alpha cannot technically be “modeled”) and run it back in time using real market data to see how it would have performed.  The model is run once as a long-only portfolio and then again using any number of 1X0/X0 strategies.  Comparing the performance of the models can yield some insight into whether the short extension itself adds value to a given alpha model.

The latest to conduct this analysis are Carl Armfelt and Daniel Somos, graduate students at the Stockholm School of Economics.  Armfelt & Somos selected a set of basic Fama/French factors to create their alpha model and ran it all the way back to 1927.  Here’s what they found:

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Hedge fund managers often contend that long-only managers lack the skills required to short-sell.  They will point to things like the fact that short positions will actually grow as they move against you (unlike long positions which shrink as they move against you).  They will also point to the fact that shorts tend to be driven more by catalysts than longs.  But one of the most legitimate concerns raised by hedge fund managers is the simple fact that good short ideas are often in short supply.

This was a concern raised last June in this MarketWatch article (see related posting, “So Much for Double Alpha”):

“Some equity hedge funds have quit short selling stocks because the strategy is riskier in a rising market and has become too crowded to be profitable. Instead, more managers are shorting exchange-traded funds. That’s a problem, according to some experts, who argue that using ETFs to hedge equity portfolios is a poor substitute for the real thing.”

“ETFs are also indexes, and so, by definition, they provide so-called beta — that is, the return generated by the market. Hedge-fund managers are in the business of creating alpha and outpacing the market benchmarks. So if they build short positions with ETFs, that part of their strategy will track whatever portion of the market they’re betting against. That could end up looking more like beta than alpha.”

While it may be true that hedge funds are in the business of creating alpha, 130/30 funds may be a little different.  Institutional investors, the early adopters of these hybrid strategies, seek alpha too.  But they do so with a watchful eye to volatility (known to them as “tracking error” vs. a benchmark index).  The key ratio for them is the “information ratio” (alpha/tracking error).

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Those unfamiliar with the inner workings of a parliamentary democracy always find the hoots and hollers accompanying parliamentary debate to be a source of great entertainment.  Every week in countries around the world various prime ministers subject themselves to intense, direct and sometimes vicious attack.  Some countries (such as Canada) have laws actually protecting legislators from libel suits for whatever barb they throw at their fellow parliamentarians while inside the house.

On Thursday, the Canadian chapter of AIMA, the Alternative Investment Management Association held its annual parliamentary-style debate in Toronto.  This year’s resolution before the house: “1X0/X0 hybrid hedge fund strategies are simply a marketing fad.”  With more than a passing interest in 1X0/X0 strategies, we were sure to show up for the fireworks.

“Speaker of the House”, AIMA Canada Vice Chair Tris Lett was tasked with maintaining decorum in the oak-paneled main dining room of Toronto’s tony National Club (think, the club from the movie Trading Places).  Clearly familiar with the mayhem of parliamentary debate, he warned debaters only against physical attacks and the use of foreign objects (a la the Taiwanese parliament).

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