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120/20 Shorting To Go Extra Long

Over the past five years, institutional investors have taken quite a shine to a type of fund that nobody quite knows what to call. At last count, pensions and endowments had committed some $30 billion to these so-called short extension, or portfolios. Whatever you want to call them, one thing is certain: The trajectory in asset commitments is steep and upward. According to a recent Pensions & Investments

Over the past five years, institutional investors have taken quite a shine to a type of fund that nobody quite knows what to call. At last count, pensions and endowments had committed some $30 billion to these so-called “short-enabled,” “short extension,” “120/20” or “130/30” portfolios. Whatever you want to call them, one thing is certain: The trajectory in asset commitments is steep and upward. According to a recent Pensions & Investments tally, short extension assets grew by 1,129 percent in the first five months of 2007 alone. Three dozen managers now claim to offer short-enabled plays to institutions.

Los Angeles-based Analytic Investors pioneered the short-enabled space, and is among the top five institutional players, which include: State Street Global Advisors, Jacobs Levy Equity Management, Barclays Global Investors and Goldman Sachs Asset Management. All tolled, these five firms manage more than half the assets committed to short-enabled strategies by institutions.

Now short-enabled funds are starting to populate the retail space. Nearly a dozen money management firms are preparing to launch — or have already floated — short-enabled mutual funds of their own. In the past year, a quarter of a billion dollars has been rolled into the first four funds adopting a short extension structure. Two of the top five institutional firms — Analytic Investors and Goldman Sachs — manage retail products, though State Street has a suite in registration.

Why So Hot?

So what makes these funds so popular?

It's simple, really. “Short-enabled” devotees believe that a “short extension” framework (I can't decide what to call them either) can enhance returns without adding significant risk. To understand how, you should know a little something about how these funds work.

Suppose we look at a fund using a 120/20 structure. The portfolio manager invests $100 in undervalued stocks from an index, such as the Standard & Poor's 500, then shorts $20 in stocks from the pool that are deemed overvalued. Proceeds from the short sale are used to purchase an additional $20 of undervalued issues. Thus, the manager ends up with $120 invested in long positions, and $20 in short positions. That's where the 120/20 moniker comes from. In a nutshell, the long side is levered by short sales, allowing $140 to be invested for every $100 under management.

Short-enabled strategies gained traction after Roger Clarke, Harindra de Silva, and Steven Sapra of Analytic Investors published a number of research papers describing the effect of constraints — most particularly a “long-only” mandate — on portfolio efficiency. Analytic (which also manages money) researchers found that long-only portfolios leave a lot of alpha untapped. A manager may rank all the stocks in an investable universe from overvalued to undervalued, but if he isn't allowed to sell short, a lot of that information is just tossed aside. A manager stuck with a long-only constraint is forced to seek value solely from market outperformers. This is predictably tough sledding, since more stocks have lagged the S&P 500 historically than have beaten it. A long-only mandate effectively turns off the alpha spigot.

A manager who can't significantly underweight the stocks he thinks are basement-bound at best, can only shun ownership. About 80 percent of stocks comprising the S&P 500 represent very small — 0.5 percent or less — weightings in the index. That leaves the long-only manager discretion to underweight such issues by as much as (but no more than) a half-percent. Relaxing the long-only constraint allows the manager to meaningfully increase his commitment to a negative view, for example, to a 1 or 2 percent underweight or more.

As Analytic Investor portfolio manager Dennis Bein puts it, “Portfolio management is like golf. You can have 14 clubs in your bag, but if you're a long-only manager you're restricted to only using six or seven of them. A long/short portfolio really has all of them to choose from. I'll take my shot with 14 clubs any day. “

Despite the short selling, the short-enabled portfolio maintains a market exposure equivalent to that of a traditional long-only fund (120 percent long + 20 percent short = 100 percent net long). This is quite unlike market-neutral or hedged equity funds that attempt to reduce a portfolio's beta correlation; the objective of short-enabled funds is beta maintenance around 1.00.

A Better Way?

Are short-enabled funds really better? Whether a short-enabled fund is better than a traditional long-only portfolio depends upon the client's requirements. If the client is looking for clearly defined and benchmarked market exposure, wants an alpha kicker, and is willing to absorb a modest amount of active risk, then yes, a short-enabled portfolio may be better.

That's a big may, mind you. Keep in mind that a 130/30 or 120/20 structure is just that — a structure, not a strategy itself. The manager's proprietary stock selection methodology still must be relied upon to pick the right stocks — short and long — to earn alpha. Relaxation of the long-only constraint simply makes it possible for more of the manager's ideas to find expression in the portfolio, for better or worse. The adage, “garbage in, garbage out” holds true for asset management just as it does for computer programming.

Is the manager skilled? Short-enabled mutual funds are new, so track records are short. The oldest short-enabled portfolio is the Old Mutual Analytic U.S. Long/Short Fund, which adopted the 120/20 fund structure in February 2006 after spending several years as a more conventional long-only product. While the fund may be untested, the fund manager isn't. The subadvisor for Old Mutual's fund is Analytic Investors-the Lewis and Clark of the short-enabled world. Analytic launched its Core Equity Plus (120/20) strategy under the direction of Dennis Bein five years ago; its track record can be found at:

When considering a short-enabled portfolio for the retail crowd, of course one should examine a portfolio manager's institutional track record. Keep cost differentials in mind though. Institutional portfolios are run at much lower-expense loads than retail funds, so institutional performance may overstate the potential returns available to an individual investor.

What returns should I expect from the strategy? The idea is to win alpha without amping up market risk. Analytic's objective for its Old Mutual Analytic U.S. Long/Short portfolios is to exceed the return on the S&P 500 by 250 to 400 basis points annually, with volatility no greater than that of the benchmark. Likewise, UBS managers expect their U.S. Equity Alpha portfolios' volatility to match the market's while outdoing their Russell 1000 benchmark by 250 to 500 basis points annually.

What do they cost? Short-enabled funds carry higher expense ratios than traditional long-only portfolios. With annual expenses averaging 2 percent or more, it's a good idea to ask what the client gets for such costs. Dividing a fund's alpha by its expense ratio gives you a benefit-to-cost ratio that can be used to compare funds side by side. A ratio above 1.00 — reflecting risk-adjusted returns in excess of costs — is ideal.

Don't forget the effect of sales loads on performance either. Class A shares carry front-end sales charges of 5.50 to 5.75 percent. These charges can eat deeply into portfolio gains or greatly magnify losses. Before sales charges, for example, retail class Old Mutual Analytic Long/Short shares (OADEX) cranked out a 22.2 percent annualized gain between September 27, 2006 and August 24, 2007. Deducting sales charges, however, cuts the fund's return to 14.45 percent, and ratchets down the fund's benefit-to-cost ratio from 4.01 to 0.87 (See sidebar for costs.)

In fact, the Analytic-managed portfolio was the only Class A product able to overcome front-end sales charges to outperform the low-cost Vanguard 500 Index Fund (VFINX) during the period. With an active risk component about one-and-a-half times the size of its nearest competitor, there's been a lot of wind at this portfolio's back. That risk manifested itself in a relatively steep nosedive during the July-August market meltdown: Old Mutual Analytic Long/Short fell 12 percent from peak to trough compared to the Vanguard index fund's 9 percent loss. Still, the short-enabled portfolio managed to quickly recover, and began outperforming again when the market turned up.

Performance can be improved by using (if available) advisor share classes, owing to their lower-expense ratios, and lack of front-end sales charges. Annual expenses for Old Mutual's advisor shares (OALSX), for example, are 1.58 percent compared to OADEX's 2.47 percent. The advisor shares' benefit-to-cost ratio, at 1.51, looks a lot more attractive than that earned by the retail shares after sales charges.

Advisor shares may not be available for every fund, so Class C shares may be your best alternative. Figure 1 and Table 1 illustrate the relative performance of Class C shares versus the Vanguard index product.

Where do they belong? To determine if these funds are appropriate for a client portfolio, keep the funds' benchmarks in mind. Most short-enabled funds occupy the large-cap space since big stocks are typically the most liquid and easiest to borrow. Not surprisingly, these funds are mostly benchmarked to the S&P 500. That said, the existing universe of short-enabled funds is most appropriate as part of, or replacement for, a client's large-cap exposure. Newer funds, however, include those benchmarked to large-cap growth and international indexes.

Short-enabled portfolios are often thought of as a type of hedge fund, but they're not. The acid test is that beta coefficient. Short-enabled funds have the same market bias — a beta near 1.00 — as traditional long-only portfolios. That's anathema to most hedge funds.

Analytic's Dennis Bein says the Old Mutual Analytic U.S. Long/Short Fund is “well suited for anybody who's willing to accept equity market risk. We really believe that this fund should be a core piece of anybody's equity portfolio, around which you have the satellite strategies like growth, value, small cap and maybe some international stocks.”

As a core position, a short-enabled portfolio delivers exposure to a concentrated benchmark like the S&P 500 with an alpha tilt. That's pretty much the same space occupied by enhanced-index portfolios, although some funds, as we've seen, are obviously more “enhanced” than others.

Where do I find them? Don't expect to get much help from fund trackers like Morningstar or Lipper when searching for short-enabled funds. Morningstar only recently created a “Long-Short” category into which absolute return portfolios, market neutral funds, managed futures and hedged equity are thrown. Short-enabled funds are excluded. The firm's database instead lumps short-enabled portfolios into the “Large Blend” category. There's a certain degree of intuitive sense in this, since the oldest 130/30 and 120/20 funds hug the large-cap core benchmarks, but the extra digging involved to determine which of the hundreds of portfolios in the category have relaxed the long-only constraint is off-putting. It's anybody's guess where funds benchmarked to large-cap growth or international indexes belong in the Morningstar universe.

For its part, Lipper's database includes short-enabled funds in its “Long/Short Equity” classification. This, at least, limits the amount of sifting that must be done to find 130/30 or 120/20-structured products.

Why 120/20 or 130/30? Why not 160/60? Analytic's seminal research found that just a soupçon of short selling — 20 to 30 percent — was needed to significantly enhance alpha generation. This has become the sweet spot for short extensions, though current research indicates that market conditions, for the most part, dictate the optimal long/short ratio. Under certain conditions, the best mix might be 110/10; in another scenario, 150/50 may be better.

There's an inherent check on the size of a mutual fund's short side, however. Mutual funds' use of leverage is statutorily limited, so you're not likely to see the sometimes-large extensions possible in portfolios not subject to the Investment Company Act of 1940. Still, short-enabled portfolios are likely to be more “active” in the future. Some funds' long/short ratios may very well fluctuate in response to changing market conditions rather than remaining fixed.

Only time will tell if short-enabled mutual funds live up to the expectations of their creators, or are, as some critics contend, a mistake in the making. The costs attached to short-enabled funds are certainly a critical alpha determinant.

Despite higher relative costs, the Analytic portfolios are clearly the pacesetters for the asset class. Manager Dennis Bein's alpha engine has been able to deliver market-beating returns for retail investors just as he's done for institutional accounts over the past five years. Only time will tell if other public fund managers will rise to challenge him.

Short-enabled funds may be used to supplant long-term core holdings, but advisors will do well to determine how they fit into existing asset allocations. Risk tolerances, especially, must be considered. The Analytic portfolios may have outperformed their peers, but they've done so because their tracking error — their degree of active risk — is higher.

Short -enabled funds are not cheap
Fund Class A Expense Ratio Class A Sales Charge Class C Expense Ratio Minimum Investment Inception Date
ING 130/30 Fundamental Research 1.58% 5.75% 2.33% $1,000 April 2006
UBS U.S. Equity Alpha 2.18% 5.50% 2.95% $1,000 Sept. 2006
Old Mutual Analytic U.S. Long/Short 2.47% 5.75% 3.92% $2,500 July 1993†
†Old Mutual Analytic U.S. Long/Short adopted the 120/20 structure in February 2006.
Source: Commodity Systems, Inc., Brad Zigler
27 September 2006 - 24 August 2007†
Fund/Benchmark Annualized Return r2 Beta Alpha Benefit-to-Cost Ratio* Long/Short Ratio
ING 130/30 Fundamental Research (IOTCX) 9.09% 0.92 1.02 -2.90% -1.12 130/30
UBS U.S. Equity Alpha‡ (BEACX) 13.09 0.93 1.00 0.93 0.33 120/20
Old Mutual Analytic U.S. Long/Short (OCDEX) 21.48 0.86 1.06 9.17 2.33 120/20
Vanguard 500 Index (VFINX) 12.19 1.00 1.00 0.32 1.71 100/0
Standard & Poor's 500 (SPX) 11.87
*Dividing a portfolio's alpha by its expense ratio yields a benefit-to-cost ratio. The higher the ratio, the more cost-effective the production of excess returns.
†To make direct comparisons, the starting date corresponds to BEACX's inception.
‡BEACX is benchmarked to the Russell 1000; portfolio statistics shown for BEACX relate to that benchmark.
The correlation between the Russell 1000 and the S&P 500 for the relevant period was 99.85 percent.
Source: Brad Zigler


There are only a handful of short-enabled mutual funds available now, but several are stacked up in registration.

“Established” funds — those launched at least nine months ago

  • Old Mutual Analytic Long/Short (OADEX)
  • UBS U.S. Equity Alpha (BEAAX)
  • ING 130/30 Fundamental Research (IOTAX)
  • GS Structured U.S. Equity Flex (GFEAX)
  • GS Structured International Equity Flex (GAFLX)

“New” funds — those launched or converted within the past two months

  • IXIS Westpeak 130/30 Growth (NEFCX)
  • Mainstay 130/30 Growth (MYGAX)
  • Mainstay 130/30 Core (MYCTX)

Funds in registration

  • Mainstay 130/30 International
  • Blackrock Large Cap Core Plus
  • Dreyfus Premier 130/30 Large Cap Growth
  • SSgA Core Edge Equity
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