Long/Short investing: Quant funds take shine off 130/30 performance

The much-hyped constrained version of equity long/short investing called 130/30 has failed to meet investors’ expectations of returns thanks to the widespread adoption of the strategy by purely quantitative asset managers earlier this year; subsequently many of these managers performed poorly during the summer’s liquidity crisis.

A number of 130/30 funds have launched since the end of 2006, when there was a lot of speculation that institutional investors were ready to place vast amounts of money into the strategy. However, performance analysis conducted by independent investment research company Morningstar suggests that many of the nascent funds have struggled to beat regular equity market returns. Observing the year-to-date returns of 38 mainly US-based 130/30-type investment vehicles at the end of August, Morningstar reported an average return of just 3.9% among the funds. The S&P 500 returned 5.2% over the same period.

"Most of the quantitative 130/30 funds did very poorly during the liquidity crisis," says Scott Bondurant, global head of long/short investments at UBS Global Asset Management in Chicago.

Funds using 130/30 strategies aim to create market-beating alpha returns on top of regular beta market returns by implementing the kind of long/short strategy usually associated with hedge funds but in a strictly constrained way. The strategy relies on relaxing the usual restriction on long-only managers going short so the manager can combine a gross long position of 130% of a fund’s assets with a short position of 30%. Although traditional long-only managers can only underweight an unfavoured stock, a 130/30 manager can actively short it while putting more money into the stocks he or she favours; hence there should be a chance to outperform.

Although a 130/30 ratio between going long and short is the most common split used, some managers opt for higher or lower ratios, such as 120/20 or 140/40. And although the most common name for the strategy is 130/30, it can also be referred to as short extension, active extension or enhanced active equity.

Bondurant says a definite performance split emerged over the July/August period between purely quantitative 130/30 strategies and fundamental 130/30 strategies – UBS relies on the latter with its US Equity Alpha Fund. A lot of quantitative managers piled into the 130/30 approach at the start of the year because the trading models they already used could easily be adapted to the strategy. Many of these managers use trading models that automatically rank securities in an index from most attractive to least attractive. They therefore already had the systems in place that could decide which stocks should be run as short positions and which as long. The systems could then be set to put in place an optimized trading portfolio based on a 130/30 constraint.

The problem was that a lot of the quantitative managers were running market-neutral strategies alongside their 130/30 funds, and these tend to use leverage to increase potential returns. "There was a surprisingly large amount of similarity in the portfolios of the quant managers," says Bondurant. The funds were all placing similar bets, which proved to be a mistake when markets started to move against those positions. Suddenly, the funds’ risk models were telling them they had to de-leverage their market-neutral strategies, and as they struggled to do this the managers were forced to sell the same securities that were in their 130/30 portfolios. The result was that they effectively locked losses on the 130/30 and dramatically underperformed, to the extent that some were 7% down, says Bondurant.

Fundamental managers did not suffer nearly as much, and it is these managers that are likely to still be operating their 130/30 funds a year from now. "That was the nice thing about 130/30. For those that could hang on and not de-lever, there was a strong rebound," says Bondurant.