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Selling short is the new frontier

Date: Tuesday, March 4, 2008
Author: Anuj Gangahar, FT.com

Shortly after being installed as chief investment officer at Calpers, the largest US pension fund, two years ago, Russell Read began making discreet enquiries about using short selling to boost the overall size of his equity holdings.

Mr Read was looking in particular at quantitative managers offering so-called 120/20 strategies. These allow an otherwise conventional equity manager to sell short individual stocks worth up to 20 per cent of its portfolio value and invest the proceeds in additional long share purchases.

Since then, the use of such strategies has exploded, particularly in the US. In fact, investors seem to have settled for an extension of the strategy up to a 130/30 ratio or in some cases even 140/40.

Merrill Lynch recently estimated that $75bn is invested in 130/30 funds, predominantly on behalf of pension funds. It further estimated that the market could reach $1,000bn in the next five years.

Managers in the US in particular have shown signs of trying to extend the 130/30 offering into the retail realm. Fidelity, BlackRock and Bear Stearns are thought to be close to launching 130/30 funds for individual investors. Others including Janus already have dedicated funds up and running. In Europe, 130/30 funds are likely to become more popular as they are now enabled by Ucits III regulations governing cross-border investment funds. These allow long-only managers the leeway to take certain short positions.

F&C Investments is expected to expand its range of 130/30 funds in the near future with European, pan-European and Asian offerings thought to be in the pipeline.

Quantitative managers took the lead in the early days of the 130/30-style strategy because it requires vigorous attention to risk management and analysis of expected risks and returns. Most 130/30 strategies either use quantitative models or are in effect index trackers with a long/short hedge fund overlaid on top.

Investors are attracted to the startegy because its use could result in managers potentially improving returns simply by lifting the long-only constraint on some funds.

With the proliferation of hedge fund managers, the relaxing of long-only constraints opens up what a traditional portfolio manager can do. Insurance companies, government pension schemes and corporate pension schemes have begun to use it, to varying degrees, as a means to post more competitive returns.

The operational requirements and provisions needed to accommodate a 130/30 strategy are fairly straightforward. Although the primary rationale for 130/30 mandates is more efficient and prudent risk management, which is even more vital given recent market turmoil, a manager could use the greater freedom to take larger active bets than could be taken in a conventional long-only assignment.

However, as a general principle, investors such as the risk-averse fund managers at Calpers wish to manage their risk actively within predetermined low-risk frameworks. To this end, the 130/30 strategy seems an ideal mix of potentially higher returns and prudent risk management.

But the fact that the strategy allows a certain amount of shorting, which still scares many everyday investors by its mere mention, means mandates to run 130/30 and similar strategies on behalf of public funds such as Calpers are awarded only after the strictest of vetting.

Meanwhile, a new report says that 130/30 strategies have created more revenue streams and, in turn, more competition among brokers and custodians, as well as creating a new asset class. Brokers and custodians are converging in offering both custody and financing to 130/30 funds and both groups stand to earn $1.26bn in annual revenues from 130/30 strategies by 2012, according to the Vodia Group.

Brokers have made substantial marketing inroads with institutional investors, 44 per cent of which say that they would custody their planned 130/30 investments with a prime broker.

As well, 130/30 funds are eroding boundaries in the asset management industry by speeding up the already blurring distinctions between traditional long-only asset managers and long/short hedge funds. As a result, asset managers are moving towards hedge funds in pricing.

For all the hype concerning 130/30 funds, institutional and retail investors are just beginning to test the waters for hedge fund-like strategies. The Vodia Group survey found that just 14 per cent of institutional investors said they had already invested in 130/30. The flood of money into 130/30 strategies seems to be having a detrimental effect on the hedge fund market, which still suffers from reputational problems among conservative institutional investors.

One fund manager says:”If you take the average hedge fund trustee and ask them to weigh the pros and cons of investing in hedge funds against those of putting money with a third party manager specialising in 130/30 strategies, that trustee is more likely to go for the latter.”