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Short circuit

Watch out investors! We have had special situations, focus, best ideas and unconstrained funds. Now a new fashion is about to hit us in the shape of 130/30 funds. One of the first out of the blocks is UBS, which will use the talents of its US team under Thomas Digenan.

I can see plenty more groups launching these types of funds because the fund manager has more ammunition at their disposal. In particular they should (in theory) be able to make money from shorting stocks. Effectively the fund is 130 per cent invested on the long side and 30 per cent invested in shorts. Investors thus have a net exposure to the market of 100 per cent, but an effective exposure to the fund manager’s active decisions of 160 per cent.

Are you with me so far? It should be easy to explain this one to your clients.

There appears to be potential here for higher returns without higher overall market risk. Of course, the whole question of risk within these funds is somewhat complex. It seems to me that, at a stock level, the risk is surely higher if a short goes horribly wrong? Remember that a short position gets bigger when it goes wrong, while a long position gets smaller.

The research focuses purely on identifying mispriced securities. UBS believes that since 1980 the 20 per cent least attractive stocks (that is, most overvalued) have had an annual performance of -3.1 per cent relative to the S&P 500. By comparison the most attractive 20 per cent (the most undervalued) have delivered an annual outperformance of 5.4 per cent.

It is interesting to note that Mr Digenan believes an extra skill set is not required for shorting, nor does he believe it dramatically changes the risk profile of the fund. Rather, he sees it as another way of carrying an underweight position on a stock. As the UBS investment process is so deeply involved in identifying mispriced stocks he clearly believes that a fund such as this gives him the extra firepower to add value through every aspect of this research.

In addition to this UBS has conducted some research on the optimum long/short mix by looking at the effect it has on the information ratio. The findings revealed that as the exposure increases, so does the information ratio, in other words improving your returns for the level of risk to which you are exposed. This does, however, occur at a declining rate of change. UBS’s understanding is that the optimum exposure is in the region of 120/20 to 140/40. Hence the 130/30 concept.

The long position exposure will be around 50 to 70 stocks with a typical weight of around 1-4 per cent and a maximum position of 7 per cent over the benchmark. Short positions will be around 30 to 50 stocks with a typical weighting of 0.25-1.25 per cent and a maximum absolute position of 3 per cent. Sector weights will be plus or minus 5 per cent with a maximum of plus or minus 12.5 per cent relative to the Russell 1000 index. The anticipated portfolio beta will be between 0.5 and 1.1 with a tracking error residing between 4 per cent and 8 per cent.

In conclusion, the whole concept of 130/30 funds looks an interesting one and intermediaries are going to have to get up to speed quickly. UBS already has a US-domiciled version, which launched in September 2005 and has outperformed the benchmark by 3.6 per cent gross of fees. However, if it replicates similar performance with UK-domiciled launch the annual management charge will erase much of that outperformance.

I have a similar issue with Mr Digenan’s long-only fund, where he does not seem to have added much value. Given that this is one of the better-performing US funds it perhaps doesn’t say much for the sector.

Mr Digenan certainly has plenty of faith in this new concept as he has transferred all his assets into the 130/30 fund from the long-only version. It is great to see that level of conviction from a fund manager, but I think we will need to review this fund again once he has got a year or so under his belt.


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