The short-term future of 130/30 funds has been thrown into doubt as a result of the short selling ban over-staying its welcome. Consultancy the Tabb Group made headlines last year with its prediction that the market for 130/30 funds would reach $2 trillion by 2010. But according to a Financial News report on the weekend,
“…Larry Tabb, chief executive of Tabb, said: “I do not see how these funds can work if they can’t short. The whole model may be in jeopardy.”
The article goes on to say that Tabb has substantially revised its predictions for 130/30 sales. And he may well be right. Invesco, for one, has taken a pending Australian 130/30 fund off the barbie for now.
As we have reported before, many 130/30 funds performed poorly in August 2007 because most tend to be quant funds. That tendency to use quant models has apparently bitten 130/30 funds in the butt once again. As one expert told Financial News:
‘”Managers with quant models for generating trades will probably have their heads in their hands. Not only will the quant models have to be redeveloped, but the managers will lose months if not years worth of model evolution, back-testing and intellectual investment. I can predict a few horror scenarios where code and expertise in these models may have been lost.”‘
The expert went on say that all quants (including those of the 130/30 persuasion) will have to stop trading until their models can be updated. For funds making hundreds if not thousands of trades a day, the strategies will simply cease to executable.
But despite these operational challenges, the chart below from Bloomberg.com shows that the S&P 130/30 Index – in blue – has outperformed the S&P 500 – in green – over the past year (albeit by a tiny amount and with a worryingly high correlation):
As we have argued extensively on this website, the fundamental rationale for 1X0/X0 investing remains sound even in the face of questionable shorting skills, inflexible quant models, or a ban on shorting one fifth of the S&P 500. As Russ Kamp, head of Invesco’s quant strategies, tells Financial News:
“…the original rationale for the funds should ensure they prosper once market rules are relaxed.”
While the list of banned substances now includes short positions in many non-financial names, the financial sector itself does not represent an overwhelming portion of many 130/30 funds. JP Morgan, managers of arguably the world’s largest 130/30 fund has been running a -3% short position in financials all year according to its website. The fund ended September with a modest -3.1% position, far from a nail in the coffin of the strategy (the fund was, of course, also around 17% net long in financials.)
According to its website, the JP Morgan Select 130/30 fund outperformed an S&P 500 benchmark by a few percent over the past year. The chart below shows cumulative out performance according to the fund’s website:
While investors might be railing against “complex” financial instruments right now, plain vanilla long-only beta has been a guaranteed loser this year. Ironically, more complex skill-driven instruments may come out of the current calamity looking relatively good. Still, as Fund Strategy points out, asset managers might want to wait a few months before moving forward on 130/30 plans. Reports the magazine:
“Toby Hogbin, the head of product development at Martin Currie, says that since absolute return and 130/30 funds rely on interaction with investment banks for the use of derivative, they are the funds that will face the biggest challenges in current market conditions.
He says: “The current turmoil in the investment banks makes the establishment of these relationships very challenging and therefore its probable there will be fewer launches of products of these types in the nearer term.
“The problem is, in these markets, investors will be looking for these types of strategy. So the challenge for asset managers moving into 2009 will be to deliver robust products to match investor needs.”
Two trillion? Okay, maybe not by 2010. But it’s too early to write off this form of alpha-centric investing just yet.