In the past few weeks, State Street, Legg Mason, TD Asset Management, Bear Stearns and other asset management firms have introduced new 130/30 funds; all told, about 140 of these funds exist today. But Colin Bugler, director of prime brokerage for RBC Capital Markets, says these asset managers will face intense competition and will need to ramp up their technology infrastructure, particularly those who are new to the business of shorting stock. (To short a stock is to borrow shares from a broker and sell them to another buyer, with the obligation to buy the shares back at some point in time and return them to the lender. It's a bet that a stock's value will drop, enabling you to buy it back at a cheaper price, while having already pocketed the profit from the original sale at the higher price.)A 130/30 fund invests 30% of its investable dollars in a short portfolio; the cash received for selling those stocks is used to increase the long portfolio to 130% of assets.
The good news is, investors are demanding 130/30 funds, Bugler says. "Through choppy markets like the ones we've had lately, something that sounds like it offers long/short protection from the downdraft is appealing and people want to explore that," he says.
The thing to be wary of, however, is that the sudden burgeoning of 130/30 funds could cause lemming-like market activity. 130/30 funds, especially quantitative ones (in other words, funds that rely on mathematical models to make investment decisions), typically use a benchmark such as the S&P 500 to determine which stocks are likely to underperform and therefore should be shorted. If many quantitative funds use the same indices, they could all identify the same shorts. In fact, last summer many quant funds didn't perform well; their models all failed to factor in credit market problems. On the other hand, the emergence of new 130/30 funds that are managed using fundamental analysis - using a combination of quantitative tools and qualitative assessments to determine the value of an investment -- could lead to a wider range of short selections, because people have different opinions on different stocks.
Traditional asset managers starting 130/30 funds face two additional challenges: a real or perceived lack of experience and a lack of technology infrastructure for shorting. "Investors are slightly skeptical that these long-only managers who have only ever held long equities actually have the ability or the technology to identify the short-selling aspect of this," Bugler cautions. He notes that hedge funds are starting to enter the 130/30 space, which so far has been filled with long-only shops, because they can demonstrate a good short selling record. Bugler wonders if eventually some hedge funds and long-only investment managers might partner up to take advantage of each other's expertise -- one being a good stock picker and the other good at identifying shorts for the portfolio.
On the technology side, traditional asset managers need to adapt to new things -- like measuring their short-side risk, borrowing securities and factoring securities lending fees into their profit and loss -- that they never had to cope with on the long side. "Investors are going to want to see that these firms have expertise not only from an intellectual capacity, but from an infrastructure, technology, compliance, order management, and execution perspective as well," Bugler says. They may need to turn to portfolio management software designed for hedge funds, for instance. They may need to invest in new risk management systems that will capture short positions and value that risk appropriately; and technology that manages loans, collateral and securities lending fees.