As the footnote to Chuck Jaffe’s recent MarketWatch piece on 130/30 suggests, his opinion carries a lot of weight (“His work appears in dozens of US newspapers”). So when he presented such a negative view of short-extension strategies, we felt compelled to explore his arguments further. Unfortunately, while he presents an adequate understanding of the strategy, he is too quick to write off the approach.
His April 20th commentary is entitled “Long on shortcomings: Numbers don’t add up for faddish 130/30 funds” and his main argument is that “early returns don’t seem to justify the hype”. While that may indeed be the case, extrapolating from these early returns is premature at best and totally inappropriate at worst.
Headline-writers as “dozens of US newspapers” are getting creative with Jaffe’s piece:
- “As the latest fad in funds, 130/30 is looking overblown”
- “Fidelity follows dubious fad by opening 130/30 fund”
- “Look beyond hype of trendy plans like 130/30 fund”
Stretching the data
Unfortunately, readers in dozens of US cities are now getting the wrong idea about 130/30 funds.
For example, Jaffe references research conducted by the UK-based Investment Week magazine:
“An analysis by Investment Week magazine recently noted that 130/30 funds are ‘largely failing to outperform their long-only peers since they started coming to market last year.'”
But this quote was not the conclusion of the “analysis”, but rather an editorial comment on a previous story in the magazine. That previous story included an analysis of Q1 2008 return only.
Further, the “analysis” upon which Jaffe bases his argument was simply a survey by Investment Week of 8 UK-domiciled 130/30 funds available to retail investors – hardly a statistically significant sample.
Jaffe also says that 130/30 reminds him of “most market neutral funds [which] have been extremely neutral about the market, unable to make decent money in all market conditions.”
Funny line, to be sure. But with the exception of a handful of market neutral mutual funds, funds following this strategy seem to have made plenty of “decent money”. The chart below compares the HFR Market Neutral Index with the S&P500 over the past 3 years (and without the stomach-churning volatility).
A fair comparison?
Investment Week suggested that when a 130/30 produces negative alpha, “…investors will be better off sticking with good long-only managers…”. But is this not self-evident? How can one compare a losing fund (of any type) to a “good” one? The better comparison would naturally be between a “good” 130/30 fund and a “good” long-only fund.
Really a unique asset class anyway?
Such rushes to judgment reflects a popular belief that, like hedge funds, 130/30 funds are a unique asset class like, say, growth stocks or real estate. Aside from modest technical differences, 130/30 funds are simply an extension of the active management that makes up most mutual funds already. Active mutual fund managers start with a benchmark and create under-weights in the stocks they don’t like and over-weights in the stocks they like (essentially using the proceeds freed up by selling the dogs). Unfortunately, active mutual fund managers cannot underweight more than the benchmark weight in any particular stock and they are forced to stop selling when the weight hits zero. A 130/30 manager, however, doesn’t have to stop underweighting when she has sold all of a stock she doesn’t like. She can therefore fully express her opinion on the stock.
If an index has a lot of constituents – say, the S&P500 – and the average weighting is small – say 0.20% – then the chances are that the manager will need to underweight the dogs more than technically feasible. But if the index had only a few positions in it – say, the Dow – and the average weight was over 3%, then the manager might actually have enough room to significantly vote against a stock (e.g. a 3% underweight) without the need to short. Both managers would be making similar active bets, yet the S&P500 manager would be considered by the media to be in an entirely different asset class – a “faddish” “dubious” “overblown” asset class.
The point here is that 1X0/X0 really isn’t that different from active long-only investing. Expected outperformance or underperformance depends on the manager and strategy, not the extent of active management. An Asian 130/30 fund and a UK 130/30 have as much in common as an Asian mutual fund and a UK mutual fund. Imagine if Asian long-only mutual funds underperformed for a quarter, a year, or even a decade. Would we say that all long-only mutual funds were therefore a bad investment and that a “good” T-Bill was a better bet?
“Early performance” driven by many factors beside the short extension
The performance of 130/30 mutual funds have been mixed not because of some over-arching characteristic of the so-called “short-extensions”, but simply because a) many early entrants were quants (a strategy which has underperformed recently and b) the timeframes and sample sizes have been statistically insignificant (as in the above Investment Week story).
This is not to suggest that 130/30 doesn’t face challenges (e.g. does true alpha really exist?). But these are largely the same challenges faced by long-only active management. Unfortunately for headline writers, short extension strategies are neither magical nor dubious. Jaffe quotes Morningstar’s Russel Kinnel who sums it up well:
“There will be some good funds in this area, but it’s too early to know which ones, or if they’re even the ones that are open now…”