13030: Here Comes the Wave

The likely increase in the number of 13030 portfolios

PHILIP MIDDLETON and CYNTHIA MAYER

Expect an increase in the number of 13030 portfolios

We are expecting a wave of asset managers to begin offering 13030 portfolios this year, as the gap between traditional managers and hedge funds continues to narrow.

13030 the best of both worlds?

13030 can be seen as an attempt to take the best from both worlds. It is a combination of a 100% long exposure, 30% of short selling and an added 30% of long exposure coming from investing the proceeds of shorting. It is a beta one product, as it is 100% net long, but it allows the manager to add symmetrical long and short positions as well, and increases the proportion of stock-specific risk, rather than market risk. In addition, the 13030 portfolio would also give the fund manager freedom to implement high conviction long and short ideas with equal force. Theoreticians argue that they also produce alpha more efficiently.

More precise risk control

Relaxing the ban on shorting allows managers more fine-grained risk control. It may well be that a fundamentally driven long portfolio will bring with it a set of industry-specific risks, for instance. A manager could use shorting to neutralise these. Equally, managers could find themselves taking a market-cap risk they do not want. The ability to undertake modest shorting could provide a means to deal with this, as well.

About $50bn in assets so far, but growing rapidly

Pensions have been early consumers of 13030 strategies, responsible for most of the estimated $50bn invested in 13030s. Quant managers at larger US firms have been early providers, in many cases, in part because their stock-ranking strategies lend themselves to shorting. But fundamental managers and hedge funds are increasingly offering or considering the portfolios.

Evolution is positive, but some potential risks

The proliferation of 13030 portfolios is a positive, in our view, in that they add to the repertoire of traditional managers and should produce greater flexibility and innovation. Fees are attractive, as the format emphasises asset manager skill. On the downside, we expect 13030 portfolios could add risk control and compliance costs, and a flood of introductions could prevent some from gaining scale or increase pressure on fees.

Why 13030 as opposed to 300200?

We think that there are some sensible, pragmatic reasons why 13030 has become a widely accepted yardstick. If shorting is harder from a liquidity perspective than going long, it makes sense to choose a preponderance of long investments. If short ideas are harder to come by than long ones, the same argument applies. In terms of market positioning, there is something to be said for an approach that can be seen as long plus rather than hedge minus. 300200, we think, would very readily be seen as an aggressively leveraged long/short fund with a long bias. In reality, just as long-only funds tend to hang onto some cash, we doubt if there will be much noticeable difference between a 13030 fund, a 12525 fund or a 13535 fund.

Trends in asset management

In some domiciles, such as European retail, there are regulatory reasons why 13030 has moved up the agenda recently. UCITS III is a major boost here. In many areas, though, its emergence is more a reflection of broader industry trends.

We have recently produced an overview of the European asset management industry and a few highlights from the report help to illustrate industry developments.

Benefits to asset managers

We believe there are considerable benefits to the asset management industry in adopting more advanced hedge fund-like strategies in Europe. These include:
 

  • Increased margin: A greater allocation to alternatives has led to an increased revenue overall.
  • Increased ability to retain/recruit staff: Hedge funds have been talent magnets for the past few years. Mainstream managers' ability to offer more hedge fund-like strategies is therefore a key potential weapon for recruiting staff.
  • De-beta-ing performance: In our view, it is positive for quality of earnings for a manager to be exposed to a number of factors of performance, rather than predominantly beta. More alternative-like strategies achieve this.

Drawbacks

Every silver lining has a cloud. Here are a few:
 

  • Systems costs: Moving away from long-only investing requires more sophisticated systems, with a much heightened stress on risk measurement. In some formats, this is a regulatory requirement. Elsewhere, it is simply sound business practise.
  • Long-only managers not encouraged to find short ideas: There is a good incentive to take a strong positive view on even a relatively lowly weighted stock, as material active position can be taken here. There is next to no incentive to decide if a lowly weighted stock is anywhere on the continuum between mediocre and destined for Chapter 11.
  • Finding alpha: In our view, this is the greatest challenge. Alpha is, even on an optimistic view, a zero-sum game in any individual asset class.

Strong growth likely

Our view is that 2007 should see strong growth in 13030 funds. We base this view on a range of conversations with executives involved in the asset management industry in both the US and Europe, as well as general industry trends. We expect them to be extended to a growing variety of styles such as EAFE, growth or even sector funds, assuming the underlying securities can be shorted. For example, large quant managers expect to see continued strong demand in the institutional arena, as their 13030 quantitatively oriented strategies enable their pension plan clients to generate alpha in a risk-controlled fashion. And, according to a 4Q06 study by Casey Quirk & Associates, institutional investor allocations to hedge funds are expected to grow to 10% in 2008 from 6% in 2006 (for those institutions in the study that have an allocation to hedge funds). However, these managers are seeing more active adoption of these strategies by pension clients as substitutes for long-only equity strategies. Thus, given that these managers can target a much broader pool of strategies within their client base, we expect institutional growth to remain very robust over at least the intermediate term.

More fundamental

The quants have made the running so far, and we wouldn't be surprised if they continued to make progress, as they have a track record and market position to help them command attention. Their major success so far has been in the US institutional market. In theory, presented with an index, a quant would construct a 13030 product around it just as easily as a long-only one. In reality, the investment approach's success would have to be validated market by market, and local regulations and liquidity issues have to be grappled with. That said, we see no reason why the large quant players should not have products based on a pretty broad range of international indexes

Institutional funds and retail

There is no reason why the quant product range should not be put into a variety of retail formats, as well. And we imagine that these strategies could be put into ETF format. However, we would guess that fundamental managers might make more inroads in the retail market. This is partly a matter of perceived consumer preference, partly a reflection of the fact that many mainstream managers have strong retail marketing presences geared to supporting the sales of actively managed products.

By Philip Middleton, Research Analyst & Cynthia Mayer, Research Analyst, Merrill Lynch, Pierce Fenner & Smith Ltd.