The FTSE 100 has risen almost unchecked for four years. Leading names such as Anthony Bolton are suggesting that the bull run is starting to run out of momentum. Bolton has taken steps to increase the cash weighting on his Fidelity UK special situations fund and we have already been told by his successor, Sanjeev Shah, that he will continue with the same bearish approach when he takes over next year.
These comments highlight the problem that long-only managers have in that they can only invest in companies where they think share prices will go up. They have not been able to speculate on share prices that might fall which has been the domain of hedge funds.
Instead of being able to make money on the downside, traditional long-only managers have had to move their money to a halfway house – cash – to protect against share price falls rather than using the potential to make money from falls.
That restriction changed recently with the arrival of Ucits III flexibility. This has allowed pseudo-hedge fund behaviour and now the fund management industry has developed a new investment solution called 130/30 investing.
This approach seeks to provide excess returns over the benchmark index, known as alpha, with a level of risk similar to the benchmark. The approach can be used across different equity markets, for example, the US, UK, Asia or Europe. It aims to deliver higher returns to investors by capitalising both on overpriced and underpriced stock opportunities.
A manager constructs a typical long portfolio by picking what he believes are the most underpriced stocks and also selects a short part for the same portfolio of what he believes are the most overpriced stocks. The 130/30 name comes about because the total portfolio is invested on average 130 per cent in long positions (including gearing) and 30 per cent on the short side – or the same as having 100 per cent invested long.
The long part of the portfolio acts like a typical equity fund where the manager aims to buy stocks that will outperform the market and deliver capital growth potential.
For the short portfolio the manager selects stocks he believes are overpriced and expects to fall back.
The manager will “borrow” the stock from a market-maker and then sell the stock, even though he does not own it, at the current market price. At a later date, the manager will then return the stock to the lender.
The short sale will have been successful if the manager is able to buy the stock and return it to the market-maker at a cheaper price than he originally sold it for. Alternatively, if the share price at the end is higher than at the start, the position has not worked and the fund is liable for the difference. It is important to note that most managers will have stop losses and risk controls to limit potential loss.
In reality, however, most 130/30 managers will not go through this whole process and will instead use a market counter-party, for example, an investment bank, to create the contract described above using derivatives.
A fund will typically hold a short position for at least a couple of years. If, during the course of a contract, a short position looks unlikely to be profitable, due to a positive change in prospects, there is usually the opportunity to close the position early.
By delivering additional alpha both from the long and short components of the portfolio, the fund aims to provide investors with higher outperformance over the medium to longer term than a standard long-only fund.
Investors should be aware that while 130/30 funds will have similar market risk to a regular equity fund, they will tend to have more active risk because of taking short positions.
A number of new 130/30 fund launches are planned in the near future. One launch that has recently been announced is the UBS US 130/30 fund. This is a 130/30 version of Tom Digenan’s long-only UBS US equity fund, which we have on our Chelsea Leaders’ buy list, which is due to launch in July.
Crucially for me, the company has form as it manages around $1.7bn in US 130/30 strategies.
I think the product an interesting addition to those on offer at present and in steady or uncertain times I think it is going to appeal.
As with new concepts and new products, we expect there to be an incubation period as investors and advisers mull over the product capabilities and dissect it.
It will not appeal to everyone as the total risk is higher but I think 130/30 products will have their place in portfolios.
Once a few more funds come to the market and start to get track records, I think people will start to take more notice.
We all have clients who are looking to diversify away from the main asset classes and some of those will be willing to invest outside of long-only portfolios. The product spec for 130/30 makes a compelling argument but the proof will be in the performance.
I am going to take a calculated risk with these products and recommend the UBS fund from launch. My reasons are simple enough. Digenan has a good long-only track record and we are supporters of his fund. He has a demonstrable record of shorting successfully on his existing fund, which is not as easy as it sounds, and UBS has a good track record in 130/30 products in other markets.
I think these funds will make interesting additions to my clients’ portfolios and I am willing to be an early supporter. I fully expect the bandwagon to roll into town shortly afterwards.