Conceived after the introduction of more relaxed Ucits III investment regulations, 130/30, or short extension funds, are starting to gain more traction, at least among fund management groups, which continue to roll out products. According to a survey of investment managers and administrators by Investit, the consultancy, 130/30 investments are the number two priority for 2008, behind data management. But the adoption of the new structure puts a significant strain on systems and operational procedures.
Ucits III allows long-only managers the freedom to take limited synthetic short positions. In a 130/30 portfolio, the manager shorts 30 per cent and is able to reinvest the money earned from short selling and go long 130, the idea being that the fund provides market exposure, but also magnifies alpha by increasing the weighting of high-performing stocks. The use of derivatives and shorting techniques, more common among hedge fund managers, has created the illusion that such products are “hedge fund light,” somehow capturing the market neutrality of an absolute return fund without the risk.
While adamant that short extension is not an alternative investment product, Celeste Dias, head of product development at Threadneedle Investments, says that experience of running hedge fund operations is an important component in rolling out 130/30 products, as the infrastructure required for processing and risk management of the short side is widely used by long-short hedge fund managers.
Bring the two together
“It’s a sort of a marrying up of the two,” Ms Dias says. “Part of the Ucits III requirement is that if you’re using derivatives for investment purposes, you need to have a very robust risk management process in place – that’s the overall investment risk in the portfolio, so you need to be monitoring that,” she says.
“And the other part is in terms of attribution analysis and back testing, stress testing, all of that,” Ms Dias explains. “A lot of those types of risk reports we have been doing on the hedge fund side for a long time, so it wasn’t a case of looking at a blank piece of paper and working out how to do this, it was more a case of seeing what we currently produce on our hedge book, looking at what we currently do on our long-only book and bringing the two together.”
Ms Dias says that infrastructure could be as significant a factor as manager experience in determining the eventual success of a short extension product. “Those two could make or break these. A lot of the smaller houses with no hedge fund experience or hedge fund infrastructure - I think it’s a huge challenge for them to actually make a success of these. It’ll be interesting to look at the space and see which 130/30 products make it and which ones don’t.”
Jan Birkmanis, head of product management at SunGard Alternative Investments, agrees that a lack of infrastructure and operational expertise could send some of the fledgling 130/30 funds to the wall, as there are significant challenges that would strain existing practices and systems. “[130/30 managers] need to be able to trade capture on the additional assets, they need to be able to manage the positions, manage the different types of lifecycle events, manage the leverage and the exposure. They need to be able to manage the funding and the cash,” he says. By adding short positions, the manager will add an unfamiliar new funding requirement, with a vehicle for borrowing stocks and additional market risk, that they would be unlikely to have experienced in the long-only world.
Long-only players will also have to learn to work in a more dynamic environment, Mr Birkmanis adds. “The long-only managers in the past have been focusing on going long, reweighting their portfolios and looking on fundamental reasons to buy shares. Now when you’re going short and long, the fund managers will have to be more active in the market, as the risk for going short is much larger than for going long,” he says. “People need to be able to manage limits in a much better way. They need to be able to manage stop-loss in a much better way, and quite honestly, the people doing this need to have a slightly different way of managing the funds than they currently have. They need to be much more active in the market and they need to be able to see everything in real time.”
Reaction times
As well as the ability to monitor their trading in real time, managers trading globally need to have up-to-date information on FX rates. They also need to be able to manage risk and leverage, Mr Birkmanis says. “I think that is a quite significant difference to what people in the traditional fund management space are doing today. I think that a lot of people have infrastructure that enables them to react, but not react quickly.”
A lot of tools have been developed to service the hedge fund industry’s appetite for shorting, so there are solutions available. It is now principally a question of changing the operational mindset within asset managers, Mr Birkmanis says. “They have adjusted from a market
perspective – they know that they need to compete with hedge funds, and they have probably known that for a while – but they have been slow in turning this ship around. At the same time they have had to adjust their infrastructure, and normally that adjustment is much longer, because such an adjustment [requires] knowledge of the different products and managing them,” he says. “Unfortunately a lot of people are only getting the knowledge when they are starting to do it. The core of all this, being able to give a valuable service to the end investor, is only possible if traders, management – that is the heads of the different desks and the people that are running the fund – and the compliance and risk officers are on top of this.”
 | Paul Ramsey, senior consultant at Citisoft, says that the various geneses of 130/30 funds on the market have had a significant impact on how adaptable their systems are to the new structure, at least on the decision support side. The majority of short extension funds have been launched by quantitative managers, who tend to build proprietary systems. |
“The problem with that is that you’re at the whim of the quants and the business that built the [system],” Mr Ramsey says. “And they tend to overlook things like risk. So, whilst they can churn all the numbers and come up with technical indicators to say, which ones should we be shorting? Which ones should we be buying? What are the signals to actually cover your shorts and sell back? They tend to forget all of the other factors – your VaR, your conditional VaR, cost of carry, those other factors.”
On the decision support side, the research-led funds are slightly easier to manage, says Mr Ramsey. “It’s almost akin to stock picking, albeit that shorting has different signals and different indicators, but by and large, the fund manager is looking at his universe of securities. He knows which ones he wants to short, he knows which ones he wants to go long.” That said, the cost of carry is still a major issue, he notes. “There’s really no point making 10 basis points on the upside and losing 15 basis points on the financing. You’ve got to have these cost of carry type figures coming in.”
Down the line, there are more challenges to cope with. As data goes from trading, through to the back office and the positions are loaded back into the modelling system. The problem here, Mr Ramsey says, is in how most companies manage shorting. “When people start to short, they usually put things into strategies, and the strategy has to be passed from decision support to trading, to back office and back again,” he says. “A good example would be if you want to go out and hold a long position in the index for one strategy, but you want to short as well that same position. They’re two different
strategies. In the portfolio itself they’re aggregated together, but in the strategies they’re not and… Most back offices just amalgamate them together, so when it loads back into your modelling system you just end up with one position, which you don’t want. You want two separate positions for two different reasons.”
This is a problem that often arises at companies who outsource their back office functionality, Mr Ramsey notes. “The outsourced providers typically haven’t got that capability, or have only been adding it in the past two years, so there’s a problem there.”
Active management
Such issues inevitably flow back into the front end, he adds, particularly with the higher volumes that result from more active management. “You’re probably churning your portfolio quite a lot, you’re looking for opportunities to cover and to go short, or reduce your long, or whatever the technical indicators are telling you.” This puts a strain on collateral and margin management, says Mr Ramsay.
“Collateral management solutions and margin management were typically done on pieces of paper or string and sticky tape and Excel. Now you’ve got to have really robust systems coupled into your back office valuations, make sure you know about margin calls, make sure you know the cost of carry, and that has to again, flow back into the decision support process.”
This means that the lack of integration between systems and the lack of operational capability could have a direct effect on the investment process. But in some cases the way in which these funds have been launched has followed a familiar pattern, says Mr Ramsey. “I think most companies have done what they normally do, they say, ‘we’ve got to have one of these to look competitive,’ so they launch one, or they get two quants or a new fund manager to create a new spreadsheet… they launch the fund on the back of that and then they worry about the operational stuff afterwards.”
