The new face of 130/30?

130/30 27 Apr 2008

Pensions & Investments reports that assets in US 130/30 strategies grew 22% over the past 2 quarters.  While still an annualized growth rate of close to 50%, the newspaper points out that this is a slower growth rate than the 77% experienced in the previous 2 quarters.

While P&I describes this growth as “drastically slower” than last year, the numbers are still relatively small (53 managers), so it’s tough to draw any definite conclusions from these numbers.  But we were were struck by what P&I said next: “…with most asset gains picked up by fundamental managers…”

While fundamental strategies are gaining, quants still continue to dominate 130/30-land.  As we’ve suggested before, it’s difficult to disentangle the poor performance of quant strategies in general from the performance of 130/30 as an investment approach.  A rise or fall in 130/30 assets says more about managers’ view of the potential returns from beta, their own skill-level, their clients’ demands and their own particular business model than it does about the merits of short extensions per se.  As a half-way point between long-only and market neutral funds, short extensions are simply an more aggresive form of active management, not an exotic new approach to investing.

If P&I is right, we’ll start to see a lot more fundamental long-only managers simply extend their existing active picks by shorting.  One good example was last week’s launch of a new retail 130/30 fund focused on the mining sector by Toronto-based Sentry Select.  This product is notable for a couple of reasons.  Firstly, it’s a closed-end fund that aims to distribute a regular monthly payout and second it focuses on only one sector.

The fact that is happens to also use a short extension strategy is secondary.  In fact, 130/30 is almost an afterthought in the preliminary prospectus obtained by as the manager seems decidedly bullish on mining…

“The Partnership will invest in an actively managed long/short portfolio consisting primarily of equity and debt securities (of metals and minerals mining and exploration issuers that are listed on a North American stock exchange. Sentry Select Capital Corp. believes that such securities are attractive investments because of the positive fundamental outlook for the price of many metals and minerals for several reasons, including (i) increasing demand from developing economies, such as China, India and Russia and from financial investors and (ii) constraints on supply increases. The Manager also believes that many of these securities are undervalued and many Mining Issuers have the potential for production growth and/or promising exploration prospects. The Manager also believes there are opportunities both within and outside of the metals and mining sectors to realize profits by taking short positions in securities the Manager believes are overvalued. The 130/30 strategy gives investors access to an investment strategy that is gaining popularity with institutional investors in Canada and the United States.” (our emphasis)

Unlike most quant 130/30 funds, the 30% is meant as a limit, not a requirement of the fund….

“The net proceeds from the Offering will be invested in a portfolio of securities primarily of Mining Issuers. The 130/30 strategy is designed to enable the Manager to invest 100% of the net proceeds in long positions of Mining Issuers. The Manager then has the discretion to sell short securities (in any sector) with a value of up to 30% of the NAV at the time the short sales are made. The cash proceeds from the short sales may then be used to increase the long positions by an amount equal to the short sales, up to 30% of NAV.” (our emphasis)

What manager wouldn’t want to leave open the opportunity to shorting “up to 30%” if and when the need arose?  In fact, what manager wouldn’t also want the ability to take on merger arb, convert arb, ETF and options positions?  (all of which are also included in this prospectus).

Unlike prototypical (read: “quant“) 130/30 funds, this fund is a long-only fund with the flexibility to short.  With the appropriate caveats, the prospectus even uses Sentry Select’s long-only fund “for illustrative purposes” and is quite clear that the fund uses “substantially the same strategy” as its long-only cousins…

“The Manager does not manage another product that has the identical investment objectives and investment focus as the Partnership. However, the Manager intends to use substantially the same investment valuation methodology and strategy for the Partnership as it does for Sentry Select Mining Opportunities Class, Precious Metals Growth Fund and Precious Metals and Mining Trust, funds managed by Sentry Select. To date, none of these funds has engaged in short selling, invested in derivatives or employed leverage in its investment strategy.” (our emphasis)

There is nothing wrong with this approach to 130/30 investing.  It’s just a lot different than a quant fund with 500 positions, operating at exactly 160% gross exposure and 100% net exposure (dollar-weighted and beta-weighted).

Drawing conclusions about 130/30 as a strategy from performance or growth data is like saying online shopping will never catch on because (see history, see other famous online shopping flame-outs) went belly-up in 2000.  While got it wrong, online shopping simply made sense for a lot of products and for a lot of people.  While traditional shopping is alive and well, the number of Americans who have purchased something online has doubled since threw in the towel.  For many Americans, online shopping is just common sense.

Investment flexibility leads to tracking error – and that’s what investors should be paying for.  Not index-hugging or resource beta.  If this is the new face of 130/30 – a common-sense approach for those who believe in active management and trust their managers – then that’s a good thing.

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