From the December 2007 issue of Investment Advisor • Subscribe!

December 1, 2007

130/30 Market May Open Up

Despite the growing popularity of 130/30 strategies, this market remains in its infancy and is likely to change in radical ways over the next few years. One potential transformation relates to who will eventually dominate the 130/30 space.

But first, let's define what we're talking about. In a 130/30 strategy, a money manager shorts 30% of the portfolio and uses the proceeds from those short positions to fund an additional 30% long position, resulting in a 130% long and 30% short portfolio. The strategy results in a net neutral exposure to the market of 100%.

Speaking in a general way, long-only managers whoo are looking to launch 130/30 strategies face a dilemma. Their investors are eager to invest in these funds, but many traditional portfolio managers don't believe they have the skills to manage them. As a result, most long-only managers have remained on the sidelines.

A 130/30 fund relaxes the long-only constraint, allowing the manager to do some shorting. This can be attractive to both the manager and the investor, as the shorting makes for a nice hedging tool. It represents a way to manage risk that cannot be found in a traditional long-only product.

Investors, for their part, also can be attracted to 130/30 funds from an allocation standpoint. For pension plans that have already maxed out their hedge fund allocations, 130/30 funds allow them to add more non-traditional equity investments to their equity buckets. The goal is to outperform the benchmark while minimizing risk.

However, there are some obstacles to 130/30 strategies--a major one being skill. Because 130/30 strategies require shorting proficiency, long-only managers have not always been comfortable entering the space.

Why Hedge Fund Managers fear to trend

Part of the reason quantitative managers may stop being the dominant force in the 130/30 space could be attributed to their own success as measured by their huge presence in the market. But as demand grows, managers will have to adjust. Hedge funds are careful in how they penetrate the space for fear of cannibalizing their own products. One aspect of that caution is the fact that hedge fund fees are higher than 130/30 fees.

Hedge funds have rolled out 130/30 products, but they usually remain quiet about it. Overall, the number of hedge fund participants in the 130/30 market remains small, but this trend may also begin to change over time, despite the fact that investors will be putting pressure on managers to lower their fees.

So with a growing demand from investors and, so far, little competition from hedge fund managers, it appears the sky is the limit for traditional portfolio managers in the 130/30 space, though they themselves have some adjustments to make.

All those obstacles have allowed quantitative managers--who typically have more resources and a computerized ability to pick stocks across the winner-loser spectrum--to come in and roll out 130/30 mandates. But many quantitative managers are not doing so great right now, because too many players are seeking the same alpha using similar models. In the meantime, as fundamental managers get more familiar with shorting techniques, they will become stronger competitors in this market.

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