Europe is anticipating the impact of Morgan Stanley and its new 130/30 fund to targeted to launch in 2007. 130/30 funds are regulated hedge funds or use UCITS III guidelines. They hope to garner up to $40 Billion, which would be quite close to the $50 Billion currently being managed in the United States.
Major U.S. managers, like Goldman Sachs and Barclays Global, have already enjoyed the opportunity to market this product. While many European fund managers love the product, many are a bit concerned about starting in “second place.”
Experts categorize 130/30 funds as a variation of active equity funds, a combination of classic “long-only” funds and “long/short” hedge funds. The manager has the authority to “go long” with a maximum of 130% of some level of allocated funds, while going “short” with up to 30% of total portfolio assets, resulting in a potential net exposure of 100%.
If set up as a UCITS III vehicle, it is subject to short sale restrictions, “local custodian” requirements, and the understanding that most products require longer time frames getting to the market.
Morgan Stanley, testing market fervor, found interest at about 50% from long-only funds, 30% from long-short funds, and around 20% from individual investors. Even better than mere interest, $5 Billion was targeted by the California Public Employees Retirement fund, graphically showing the positive potential of the 130/30 fund approach.
Another potential attraction to a 130/30 fund is the current fee structure. Management fees are in the range of 60 to 90 basis points! While this is higher than the usual 40 basis points required by most long-only funds, these fees are a bargain compared to the 200 basis points and 20% of positive returns normally charged by hedge funds.
Originating in the United States, 130/30 funds proliferated because of the great numbers of quantitative fund managers based there. Converting fundamental funds to 130/30 formats requires expertise that many fundamental fund managers may be lacking. The technique involves separating the long/short “alpha and beta baskets” within the managed portfolio. The alpha portion is then leveraged to produce the projected returns.
Experts have stated that a relaxation of the long-only built-in restrictions can achieve around 90% of the funds optimal performance projection. In a 130/30 setting, using a great deal of shorting, transaction costs and stock borrowing can devour a large amount of capital in relation to the hoped-for extra performance. The inherent higher exposure can cause this higher expense-to-benefit ratio.
As a result, even experienced fundamental fund managers may be challenged by the 130/30 fund structure.
The critical item of appeal of a 130/30 fund is the risk-adjusted returns generated by successful funds, called a “Sharpe ratio.” The proper management of this strategy can generate excess returns lower than the tracking error component. Hence, the attractive fee structure and potential for returns higher than many long-only funds often achieve make a 130/30 fund a potentially attractive investment vehicle, now available in Europe.
