Best of both worlds?

The structure of 130/30 funds has a long history in the US, where they have attracted much interest from institutional and family money, but less so from hedge funds, says fund manager Luke Newman of F&C Investments. Their success among small investors is because they provide a vehicle for gaining access to hedge fund-style strategies, but without the need for a sizeable minimum investment.

UBS’ US 130/30 Equity Fund’s minimum investment is only £1,000 and the group has emphasised that their product enables the fund manager to add more ‘alpha’ to the portfolio – the phrase used to describe the proportion of the fund’s overall returns that reflect investing decisions rather than general market movements. The idea is that the skill the manager exercises in these decisions enables a 130/30 to outperform a conventional long-only fund.

Newman adds that while ‘130/30’ is bandied around as a generic term for the funds, ‘enhanced alpha’ is more appropriate. There are a number of alternatives based on the same concept – ranging from 110/10 to 140/40 – that have also proved successful in the US.

So what are the benefits offered by this particular structure? Proponents of 130/30 cite the fact that they offer the greatest single advantage of short selling, which is that astute managers who pick carefully can profit from stocks that go down as well as up.

At the same time they avoid the main drawback of short-selling, which is that stocks generally move higher in the long term and to benefit requires being fully invested in the market. So, in theory at least, 130/30 offers the best of both worlds.

“There is a high degree of skew in the UK market, with the top 15 companies accounting for 50 per cent of the FTSE’s total market capitalisation. The 130/30 removes these constraints and takes an underweight position in some companies,” says Newman.

“Periods of volatility, such as the present one, are when the active stock picker can really go to work and pick up those stocks offering good prospects and attractive valuations,” he adds.

Top

At least, that’s the theory. In practice, the new funds have received something of a mixed reception from some advisers. As some have pointed out, in order for the strategy to fully realise its glittering promise, it needs to be very skilfully executed. 130/30 managers are called upon to have a significant degree of extra knowledge, as the strategy calls for familiarity with the shares they do not want to have as well as those that are in their portfolio.

The element of shorting means there is also a greater scope for making mistakes than with a long-only strategy.

“It’s a bit like a watered down version of the risk and return case for hedge funds,” says Heather Lamont, director – institutional business development at HSBC Investments.
“The shorting element for 130/30 funds is limited, but it’s still conceivable that a manager could get both their long and their short bets wrong, so there’s the potential for significant losses.”

This is one of the main concerns of Eoin Murray, head of quantitative strategies for Old Mutual. He has cautioned would-be investors to do some thorough research before they plunge into 130/30s. Murray questions whether some managers, whose experience is limited to running long-only portfolios, have the flexibility and skills necessary to achieve the new product’s potentially superior returns.

He, therefore, urges prospective investors to ensure that any 130/30 fund manager can demonstrate “true alpha identification skills”, warning that they otherwise risk becoming “guinea pigs” for any who are novices when it comes to shorting.

Meera Patel, senior analyst at Hargreaves Lansdown agrees. “I’m treating 130/30s with a degree of scepticism at the moment. They may have been quite big in the US, but they are quite a new concept in the UK,” she comments.

“The fact that they incorporate an element of shorting is a problem in my view. As a fund manager, you need to be exceptionally brilliant when it comes to shorting. Whereas in a long-only fund you can only lose up to a maximum of 100 per cent, your potential losses are infinite in a 130/30 fund.”

Patel adds that the recent weeks of market volatility have given the new products a “fantastic opportunity” to shine and demonstrate that they can be more resilient than long-only funds. Nonetheless, she suggests they still need more time in which to prove themselves to UK investors, while IFAs may face an uphill struggle in explaining in plain and simple language to prospective clients just how the technique of shorting operates.

Too early to tell

After 130/30 funds had their UK launch two months ago, analysts suggested that by the autumn investors would have enough choice to be able to select a decent performer. Given the subsequent bumpy ride that stock markets have undergone around the world, some might prefer to hold off making a decision just yet, as it is unclear how the funds have been coping.

“We haven’t seen any performance figures and in any case it’s quite likely the dust won’t have settled by the autumn,” suggests Lamont. “At this early stage ‘time will tell’ is about the best anyone can say, although more testing markets should help sort the wheat from the chaff.”

So are 130/30s a suitable investment for charities? The Charity Commission sets out its general guidance on investment policy in their CC14 guidance (see www.charitycommission.gov.uk) but says that decisions on specific investments are the province of the trustees and has no specific stance on 130/30s.

One potential disincentive, though, is the cost. As Patel points out, shorting can prove expensive and push up costs over and above the annual charge on the fund (which in the case of UBS’ fund is 1.6%).

If the fund has a high turnover, this can also push up the costs and undermine any outperformance. As the market has not yet really taken off, it’s not clear whether the additional layer of cost wipes out the benefit of any added performance.

Andrew Wilson, head of investment management at Towry Law is another sceptic. He suggests that as few managers of standard funds can claim to have beaten their benchmark index, it’s unlikely they will prove any more adept at running the significantly riskier 130/30 funds. “This just seems to be another marketing-led initiative designed to part investors from their money,” he concludes.

HSBC Investment’s Lamont adds that charities have yet to show much of an appetite. “We’re not seeing a great deal of interest so far, and we’re not actively promoting these funds,” she reports.

“Most charity investors are more concerned to see the case for a new asset class, preferably in the shape of a solid track record, than about being in the vanguard of the latest innovation. And these funds can’t yet offer that track record.”

But to any charities still keen to take the plunge into 130/30s, she advises: “If you’re looking to select funds directly, you need to have the confidence to identify the best managers and identify what they’re doing. Most trustees won’t have that expertise, so they would be better off looking to invest through a fund of funds.”

Top

To return to the September 07 features list click here