130/30Strategies Conference

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Understanding 130/30 StrategiesThis series of conferences explained the pros and cons of implementing short extension strategies in the search for alpha

THE RISE IN THE USAGE OF 130/30 STRATEGIES BY U.S. defi ned benefi t pension plans is well-known, but even as many have embraced the idea, others have been waiting on the sidelines. This series of conferences, held in San Francisco on May 7, in Chicago on May 14 and in New York on May 21, gave DB plan sponsors the opportunity to learn about the theory of 130/30 and quiz investment managers about the mechanics of implementation. Moderated by Manfred Lehmann, the former treasurer of Nestle USA and an experienced DB plan sponsor himself, the conferences kicked off with a brief discussion of what exactly 130/30 is and why plan sponsors would be interested. Lehmann then turned the podium over to James Dwinell, vice president, U.S. equities at Pyramis Global Advisors. His presentation, en-titled, 130/30 Uncovered walked attendees through the funda-mentals. He explained that a typical 130/30 strategy is an equity portfolio with 130 percent long equity exposure and 30 percent short exposure. This construction allows managers to sell short stocks on which they have taken a negative view, by relaxing the traditional equity long-only constraint. A 130/30 portfolio seeks to maintain an overall market exposure (beta), however, of a nor-mal long-only portfolio. Dwinell cited a survey that Pyramis had completed which suggested that 58 percent of larger DB plans in the U.S. were using or considering using 130/30 strategies.

Understanding the methodA 130/30 strategy is a natural extension of a long-only strategy,Dwinell contended, as by allowing shorting, investors gain a greater exposure to manager skill. In an era of low returns, the additional alpha that this exposure, with little additional risk, can provide will allow pension plan investors to minimize future contributions. But to be successful investing according to 130/30 rules, the devil is in the detail, so Dwinell spent quite a bit of time concentrating on implementation and understanding the mechanics of short selling, which was welcomed by the audience. He also addressed the two strains of 130/30 available to investors: those managers who take a fundamental approach and those who rely on quantitative methods. Each has its advantages, but inves-tors need to understand their methods in order to judge which is best for their plan.

The fi rst panel discussion of the day attempted to put 130/30 strategies into context within larger portfolio consider-ations for pension plans. Bill DeRoche, vice president of State Street Global Advisors, provided a bit of background in the decision-making process that plan sponsors go through. He said that all of SSgA’s clients in the strategy were existing long-only clients that were comfortable with the fi rm’s risk manage-ment process. He also explained that many clients were taking a wait-and-see attitude today, as performance dictates to a certain extent when investors move money into the strategy. Dennis Bein, chief investment offi cer of Analytic Investors, explained that short-extension strategies were a foreign notion in 2001 when he and his colleagues unveiled their groundbreaking research on the subject. Equity investors were either using long-only or market neutral strategies. But once it was demonstrated that a short-extension strategy could be a more effective way of capturing manager skill, investors started relaxing the long-only constraint in part of their core equity allocations. Jennifer Bender, vice president, applied research of MSCI Barra, expanded on the manager skill point, explaining that taking off the handcuffs of the long-only constraint magnifi es the effect of manager skill. This is particularly apparent if a manager is wrong on the short side, as there is an element of self-correction on the long side that is not available when shorting. The panel ended with a spirited discussion of risk and leverage within 130/30 strategies, as well as the important matter of performance attribution, an issue that was raised again after lunch.

Why transfer coeffi cients matterAfter a networking break, Analytic’s Bein took to the podium again to present a workshop on Choosing the Right Ratio. Al-though his presentation looked technical, with all sorts of graphs and mathematical equations, Bein’s messages were clear. Long-only equity portfolios, he said, put a huge limitation on his abil-ity to put his investment ideas to work. He described one mea-sure of this limitation: the transfer coeffi cient or the ability of a manager to implement ideas. He contended that portfolios with constraints have lower transfer coeffi cients. This, he conceded, is only useful if a manager is a good investor. When addressing the subject of his talk, the right ratio, Bein explained that 130/30 should only be seen as shorthand for a short extension strategy. He prefers to think of the ratio as dependent on market condi-tions and that it should change dynamically over time depending on circumstance. He showed a variety of situations when the ratio might shift. Paul Calderone, director at Credit Suisse, addressedsome of the implementation issues and choices that mightface a plan sponsor choosing a 130/30 strategy. He detailed the range of long-short investment products available, while compar-ing some of their characteristics. But he focused on a point of great interest to plan sponsors – the pros and cons of using a separate account structure for this allocation or a commingled fund. The right answer, of course, depends on theparticular requirements of the fund. However broadly a

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Attendees chat during a networking reception

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plan sponsor may have more control of invest-ment style and operating process with a separate ac-count, while also access to greater transparency and liquidity. A commingled fund provides an easier and sometimes cheaper route to access 130/30. Operationally, a 130/30 fund re-quires plan sponsors often to hire a prime broker, because of the short selling requirements. This is a new experience for many plan sponsors and requires an education process in order to un-derstand the benefi ts that the right prime broker can bring to the process, namely margin lender and a source of short liquidity. Issues that Calderone also touched on included unrelated busi-ness taxable income, which may kick in for pension plans when shorting, and ERISA-related issues. He fi nished his talk by bust-ing a few myths about short-selling and 130/30. He contended that it was incorrect to say that short sale proceeds in 130/30 are used to pay for the additional $30 of long securities, rather these are independent actions.

The challenge of short sellingAfter lunch, Manfred Lehmann provided a short speech on the plan sponsor’s perspective, explaining how he approached the alpha-beta split in the Nestle USA plan and how he would have evaluated 130/30 had it been available when he was still in this post. His questions rang true with many plan sponsorsin the audience. After Credit Suisse’s Calderone raised a number of questions about short selling in his morning workshop, he joined James Martielli, senior portfolio manager for U.S. equity at SEI, for a panel on Understanding Short Selling.As this is unfamiliar territory for many U.S. plan sponsors, the perspective of a prime broker (Calderone) and a fund-of-130/30 funds manager (Martielli) was welcome. A prime broker, Calde-rone explained is something of a misnomer; essentially it is a bro-ker/dearler that facilitates short selling by knowing where to look for shares that a manager wishes to short, so that when the trade settles, shares can be delivered. The prime broker also maintains the cash sale proceeds of the short sale and manages the collat-eral; this is a risk management function as well, so it is impor-tant that the client – the plan sponsor – is comfortable with the organization that is providing this service. Calderone explained how prime broker reporting can help clients understand the big-ger shorting picture. Martielli continued by explaining how he looks at 130/30 managers and assesses their skill at short selling, which is an entirely different beast than long-only management. He focuses on their assumptions, their transaction costs and the experience of the principal portfolio managers. Martielli specifi -cally mentioned that he wants to see real experience in the real world, not just simulations. You don’t want someone to try out 130/30 for the fi rst time on my watch, he said. The workshop presented by SSgA’s DeRoche asked the question that the audience had been grappling with all day: Have 130/30 strategies lived up to the hype? The answer is yes. 130/30 is a set of tools that allow plan sponsors and other investors to gain alpha with limited additional risk, but it relies on the skill of the manager and market conditions to make it work successfully. A short-extension strategy, if anything, emphasizes poor manager skill and in challenging fi nancial markets, as have been seen in the past year, some managers running 130/30 strategies have not fared well. Yet the same could be said for some long-only manag-ers as well. A better comparison for a plan sponsor would be to

look at a manager’s 130/30 performance against their long-only performance. The 130/30 performance should always be better, as this strategy involves additional risk. DeRoche explained that a wholesale move to 130/30 would not change the dynamics of the strategy mainly because of how little of the potential short capacity is in use.

The future of alphaA very busy day was rounded out with a panel discussion on the future of alpha, specifi cally where will it be found in the future. Jeb Doggett, partner at Casey Quirk, proposed a different cut on the issue of alpha. Pension plans need alpha, but not much is available on a de novo basis, he explained. He saw 130/30 strat-egies as part of a fi rst phase of change for pension plans, part of a movement that includes quantitative strategies with higher diversifi cation, and beta, sector neutral strategies. These engi-neered strategies allow plan sponsors to become comfortable in their core asset allocations with a very engineering approach to portfolio construction. He then proposed two further phases, the fi rst being a leveraged return approach with a tracking error of 5-8 percent rather than the 3-5 percent of enhanced indexing. A further phase involves opportunistic strategies, such as hedge funds or a best idea portfolio. Pyramis’ Dwinell saw a graying of the line between130/30 strategies and opportunistic ones, as a higher degree of leverage becomes more acceptable. As far as 130/30 specifi cally, he stated that 130/30 is here to stay, regardless of style, capitalization or geography. If the skill is available, he said, then loosening the long-only constraint provides more opportunity. He anticipated that of the many managers attempting to get into the space, however, there would be some successes and some failures in implementation. Bruce Graham, managingdirector of Shields Associates rounded out this exerciseinto crystal-ball gazing by suggesting that growth in 130/30might be more muted than current predictions. He claimed that plan sponsors are spending their time on seeking non-correlated assets and 130/30 doesn’t really deliver the levels of alpha that those kind of searches demand. Pyramis’ Dwinnell pointed out that defi ned contribution plans, as they come to be invested more along the lines of defi ned benefi t plans with an overall asset allocation are looking to 130/30 to provide a core equity component. The conference ended with participants still asking the sponsors further questions over cocktails, a fruitful day for all.

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Manfred Lehmann, conference moderator, discusses the importance of 130/30 strategies

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State Street Global Advisors (SSgA)One Lincoln StreetBoston, MA 02111Contact: Marc Brown(617) 664-6118marc_brown@ssga.com www.ssga.com

Analytic Investors, LLC555 West Fifth Street, 50th FloorLos Angeles, CA 90013Contact: Brian Haskin(213) 688-3015bhaskin@aninvestor.com www.aninvestor.com

Credit SuisseEleven Madison Ave. New York, NY 10010Contact: Paul Calderone(212) 325-4930paul.calderone@credit-suisse.comwww.credit-suisse.com

Pyramis Global Advisors82 Devonshire Street, G10ABoston, MA 02109Contact: Patrick Mc Nelis(800) 515-5902patrick.mcnelis@fmr.comwww.pyramis.com

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130/30 StrategiesPost-Conference Report

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A Webcast of the entire conference, available on thePensions & Investments website,

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