130/30 flops in Japan

One problem is how to fit active extension mandates into legacy asset allocations, suggesting that support for these quant products might come from new institutions elsewhere.
2008 was supposed to be the year when the giant pension funds of Japan began to experiment with active extension structures.

So far, it hasnÆt happened. And while fund managers flogging these quant products say itÆs just a matter of time, the possibility that 130/30 strategies and their ilk never gain traction is something to consider.

Active extension structures, also known as 130/30 strategies and sometimes referred to æhedge funds liteÆ, are usually quantitative-based means of adding shorts to traditionally long-only equity mandates. They are meant to provide enhanced active returns against a benchmark with a relatively lower increase in risk.

In a typical active extension mandate, the manager shorts 30% of the portfolio and uses the proceeds to buy more stocks, through the auspices of a prime broker. This raises the long portion to 130% of capital, and divides the portfolio into a beta, long-only bucket and an alpha-seeking long/short, market-neutral bucket. The portfolio is effectively running 160% of the capital, which gives fund managers more leeway to invest in a greater number of stocks, or to take concentrated bets on stocks they like, while the shorting is often done against an index.

Japan, with its huge state and pension funds, as well as its financial institutions, was seen as the ideal market to introduce 130/30 strategies. Active extension has been wildly popular in Australia and New Zealand, having arrived some years ago from the United States, and fund managers have spent a lot of time marketing the idea in Asia, including hosting big conferences in Tokyo.

In Japan, some of the leading proponents of active extension are AllianceBernstein, Axa Rosenberg, Barclays Global Investors, Diam, Goldman Sachs Asset Management, Nikko Asset Management, State Street Global Advisors and UBS Global Asset Management. Fund management executives at several of these organisations say not one Japanese institution has given out a 130/30 mandate; some declined to comment or did not return e-mails or calls.

Execs point to a number of reasons.

First, a big setback occurred last August, when the American credit crisis caused losses among the worldÆs leading quant strategies in the US. ôThe timing for quant funds was terrible,ö says a global executive in Tokyo.

This shook Japanese investorsÆ faith in fund managersÆ ability to handle shorts quantitatively. This could yet prove beneficial to some managers: it has forced a lot of me-too quant managers out of the market, leaving it to just a handful of serious players. And many managers have seen their quant performance bounce back.

Second, investors remain confused about how to classify active extensions. Because they involve leverage, shorting and opening a prime-brokerage facility, they look like hedge funds. But the risk/return structure is traditional: 130/30 offers a benchmark-related return, not an absolute return. Fund-management executives argue 130/30 is not an alternative investment, but should receive allocations out of traditional equity portfolios. (Technically, active extension is not a strategy but a way of structuring a benchmark-oriented equity portfolio using derivatives.)

Third, Japanese institutions are still locked in discussions with fund managers about their risk controls surrounding this investment structure. The need for a prime broker is also a stumbling block.

Fourth, fees for active extension are higher. The fund manager is running 160% of the assets and therefore typically charges 160% of the fees of a normal long-only mandate.

Fund execs in Tokyo still insist active extension makes sense for Japanese investors, particularly as opportunities to achieve high returns in developed-market equities look bleak. ôThey need to enhance returns by shorting,ö says one managing director of a global fund house. ôThey already have long/short funds, so why not do more?ö

But a Hong Kong-based regional CEO of a quant shop admits: ôWith the shorting and the added volatility, investors are wondering if 130/30 adds value after fees.ö

Some providers say they are now pitching the idea of wrapping 130/30 into a fund format, rather than as a segregated account, which would mean taking in-house the prime brokerage facility and offering a daily NAV. This has proven popular with some superannuation funds in Australia, for example.

But other executives are beginning to think active extension requires institutional investors to have in place a flexible, sophisticated governance structure, one that can embrace hybrid notions such as 130/30. One fund exec believes the first mandates for 130/30 wonÆt come from Japan after all, but from new institutions working from a clean slate. In other words, from China.
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