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 September 2008 Shorting Won't Help 130/30 Strategies Won't Turn Bad Managers Into Good Ones
Indexing is now passé. It fell by the wayside when investors found out the hard way that it was nothing more than unmanaged momentum investing. The bear market taught them that rather quickly. Hedge funds have lost a lot of their luster, too, as many sustained losses right along with traditional investments in the early part of this decade. Throw in their onerous fees, and it's hard to get too fired up about them when the markets offer subpar returns. Despite their ongoing push, it's hard to imagine that 130/30 funds aren't more than yet another mere fad. Typically by the time a "new" style makes its way to the mutual fund level, it's on its last legs, soon to be replaced by the next passing fashion. In the case of 130/30 funds, however, there's even more reason to be skeptical of not only its staying power, but its ultimate value as well.
The Long and Short of It Shorting is a technique that turns the old adage "Buy low, sell high" on its head. Essentially it's doing the same thing, but only in reverse order: Sell high and buy low. To short a stock, and investor borrows shares and sells them, hoping to replace them later when the price declines. If right, the investor gets to pocket the difference between the proceeds of the original sale and the lower repurchase price. If wrong, the investor ends up losing the difference between the original sales price and the higher repurchase price. There are additional costs involved in the transaction because the shares must be borrowed through a margin arrangement with a broker.
Those stocks flagged by managers as poor potential performers are great candidates for shorting. If the manager is allowed to do this as well as buy shares long, the overall portfolio return can be enhanced. In essence, giving the manager the ability to sell shares short as well as buy them long enables him or her to take full advantage of all his or her best ideas. Under a 130/30 arrangement, portfolio return can be enhanced by not only shorting the potential dogs but by reinvesting the proceeds in the projected outperformers. The name "130/30" comes from the formula of short selling stocks equal to 30% of the portfolio and then increasing the long end by that 30%, thus creating a portfolio that's 130% long/30% short. As an example of how this can enhance returns, consider a $10,000 portfolio. Assume the manager's long picks rise 10% while his short picks fall by 5% over the period of a year. If this was a long-only manager, the portfolio would grow by $1,000 for a 10% return. That's just what you'd expect if the individual long positions increased by 10%. But now consider the 130/30 manager. Like the long-only manager, she'd start by investing the $10,000 portfolio in the stocks she expects to increase in value. But then she'd also short $3,000-worth of those she thinks will decline, giving her an additional $3,000 to invest in the long stocks. Under the assumption that the long stocks rise 10% and the shorted ones decline 5%, at the end of the year her long portfolio will be worth $14,300 and the shorted stocks will have fallen to $2,850. To calculate the return, you'd have to subtract the value of the shorted stocks -- they're a liability that must eventually be paid off -- so the net portfolio is $11,450 ($14,300 - $2,850). This translates to a 14.5% return, well above the 10% for the long-only manager. Sounds good, doesn't it? It wouldn't be pushed so hard if it didn't. Of course this is only the positives, putting the technique in its best light. In reality, there are two very important factors ignored in the simple examples. The first is the transaction costs. There's a margin cost for borrowing shares that's an ongoing expense until the shares are finally replaced. For large managers, this cost may be almost negligible because it tends to decrease as the size of the transaction increases. Nevertheless, it is an expense that must be netted out of the gross return along with the costs associated with the purchase to close the position. These costs can have a greater impact if the long and short stocks don't move to such an extent as in the example, or even worse, if they move against the manager. And that brings up the the second and more troubling issue: The long stocks may fall and the shorted issues may rise. Because this is a leveraged portfolio, the losses from both ends will be magnified. Consider again the earlier example, but this time assume the long stocks fall 5% while the shorted ones actually rise 10%. The initial investments would remain the same, but the end result is drastically different. This time the long shares decline to $12,350. The shorted shares actually climb to $3,300. This leaves an ending net value of $9,050 ($12,350 - 3,300) for a net loss of 9.5%. The long-only portfolio would have only declined 5% to $9,500. Leverage is great when it works in your favor, but it can really sting when it doesn't.
No Magic But what's not as obvious is why the financial community thinks allowing managers to use leverage will make them better investors. Certainly there's the issue of letting them use all of their ideas, not just the long ones, but let's put that in context. If most active managers were doing a good job just picking shares to buy, you'd expect them to routinely outperform unmanaged (long-only) benchmarks, yet study after study shows only a few are able to do this and even less on an ongoing basis. To put it mildly, most active managers aren't very good long-only managers. This isn't to say they're dreadful, just that most struggle to beat their benchmarks.
If this is true, why should we think giving them the ability to short stocks will make them better overall managers? Perhaps it will because they will be able to stick with their "best" ideas and not have to move down the food chain at the long-only end, but then again, maybe it won't. What we do know for sure is giving them the ability to short -- to use leverage -- will definitely increase the risk to their portfolios. Makes you think, doesn't it? It should. Inalytics, a British financial data analysis firm, recently concluded that most managers can't successfully run a 130/30 strategy because they lack the necessary shorting skills. Inalytics founder and CEO Rick Di Mascio was recently quoted in Fundfire saying, “The industry is really not skilled at shorting stocks. The selling decisions, as a whole, systematically destroy alpha. This is just a part of the skill set that’s not commonly held.” Looking at mutual funds, as of July 31, 2008, there were 19 unique funds in Morningstar's domestic categories using leverage. Sixteen were trailing their respective Russell style benchmark, and as a group the average fund was underperforming the benchmark by 2.2%. Whether SMAs or open-ended mutual funds, the evidence suggests managers aren't particularly skilled at shorting. Why would we think otherwise? There's nothing magic about letting a manager short stocks. Granting permission to do so doesn't automatically bring the ability to do it well. Successful shorting requires analysis that long-only investing doesn't. For example, there's a significant penalty being early on the short side. Although the pick may ultimately fall in value, expenses grow as long as the short position remains open. The more they do, the greater the return necessary to offset them. Good short sellers have to know when to take their profits because a sudden reversal in sentiment can quickly make a loser out of a profitable trade. So-called "short squeezes" occur when heavily shorted stocks begin to rise. The catalyst can be specific to the stock or simply a broad market rally. Regardless of why shares begin to rise, when they do, other short sellers rush to buy back the stock and close out their positions, thus preserving as much of their profits as possible. But this increased demand sends share prices higher, further eating into short sellers' profits and leading more to try to exit their positions. Short squeezes feed on themselves, and managers who are late to exit often do so with losses. Long-only managers don't have to deal with this. Asset managers are good marketers. They're great at recognizing trends and what interests investors. They're quick to develop new products to meet these demands and almost as quick to replace them when they fall out of style. We'd suggest 130/30 strategies are the latest of these fads and as such, investors should approach them accordingly. No great investment idea can magically confer investing skills, and quite frankly, 130/30 isn't even a great investing idea. Search this site! Just enter you key word or words:
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TYLES COME AND GO in investing almost as frequently as in fashion. Ten years ago large stocks were dominating the benchmarks and overall equity returns. Active managers were struggling to keep up and indexing was the favored style. That all changed in the ensuing bear market when investors turned to hedge funds in an effort to profit in a down market. More recently, investment managers have been pushing their "130/30" strategies not only to high-end investors through separately managed accounts (SMAs) but also to the masses through mutual funds.
