Will increased fund flexibility benefit retail investors?
Writing this article in the last week of the second quarter (and thus first half of 2007) we are aware that many portfolio managers are likely to be awaiting equity market performance data with some trepidation. 2007 has thus far proved extremely difficult for investors as benchmark indices hit, surpassed (in many cases) and then retreated from multi-year and all time high territory.
The macro economic backdrop has proved equally mixed. Global economic output growth remains robust and has become resynchronised as US activity recovered over Q2 from the ultra-depressed levels of Q1. Concerns regarding inflation have increased, although the sharp rise in medium and longer dated bond yields has much to do with rising real yields, not nominal yields, i.e. more a reflection of synchronised global economic growth than fears regarding reigniting inflation.
Corporate earnings continue to grow, albeit not at the same pace as the past and equities are, in general terms, no more expensive using absolute valuation measures now than they were when the bull run really got going around the time of the invasion of Iraq in 2003. Thematically, investors have shown a strong preference for Growth at Reasonable Prices (GaRP) and this has manifest itself in the relatively unusual sight of the generally defensive sectors of the market, such as Tobacco and Food Producers performing strongly at the same time as Telecoms and Technology Hardware.
The other strongly contributory factor has, of course, been a swathe of merger and acquisition activity as bids and deals both real and imagined, have held investors in thrall. Unfortunately for portfolio managers all this background activity has made generating outperformance against benchmark indices extremely hard. Does one opt to participate in the “only game in town” i.e. attempt to chase the next bid target (like pinning the tale on an increasingly schizophrenic donkey) or does one opt for those largest mega-cap companies, still generally regarded as relatively bid-proof (although the influence of private equity businesses and activist shareholders has been gradually creeping up the capitalisation scale) and cross one’s fingers and hope that any underperformance might prove short-lived.
Professionial investors take advantage of lighter investment rules
Recent price action in BAE Systems (BAE), GlaxoSmithkline (GSK) and Northern Rock (NRK), to name just three, provides clear evidence that companies which deliver bad news to investors are being treated harshly by the stockmarket. Although share prices deserved to be marked down on negative news, the extent of the mark-downs tends to suggest more than just a rap on the knuckles.
This brings us to the key theme of this note, the ability of professional investors to take advantage of investment rule changes to short stocks in their portfolios as a means of improving performance. Readers will be all too aware that professional investor shorting is nothing new and that hedge fund managers have been taking advantage of the ability to sell shares they don’t already own in the expectation of being able to buy them back more cheaply later for years.
However UCITS 3 has provided the legal framework for traditional long-only fund managers to take short positions in individual stocks. According to a detailed investigation by Citigroup quantitative research, a typical professional long-only portfolio manager is now adding leverage to their portfolios by augmenting an existing 100% long only fund with a 30% long / 30% short element known as a “short extension”.
Investment rule changes: What Is UCITS 3?
All traditional funds launched in a particular area are subject to that area’s regulatory environment. The level of regulation is determined by the perceived level of sophistication of the investor in the fund and their geographic location. Hedge fund managers have typically chosen to operate in the unregulated arena and are thus precluded from unsolicited marketing to individuals. They are restricted to selling their funds to sophisticated investors, either wealthy individuals or professional investors. One recent trend has been that managers of hedge fund style products have been considering ways of designing products for the regulated market place.
Regulated investments can be marketed and sold to private investors for whom they are deemed appropriate as well as to pension funds and sophisticated investors who are already restricted to investing in regulated products. Funds opting to provide diversified exposure to one particular stock market can apply for localised regulatory approval in a specific country. Others, seeking greater geographic diversification, can opt to be regulated under the European Union Directive, UCITS 3 (Undertaking For
Collective Investments in Transferable Securities).
UCITS 3 represents the third incarnation of the original UCITS 1 directive which emerged in 1985. UCITS 3 was only fully implemented in February 2007 following a two year adoption period. The most striking feature of the latest iteration is that it is massively less restrictive than the original directive. The new rules allow managers the flexibility to use derivatives up to 100% of NAV for more than just efficient portfolio management and hedging purposes, the use of leverage within funds (up to 200% of assets), the creation of fund of fund structures and the ability to market the fund across international borders.
Since full implementation on 13th February 2007 UCITS 3 is already becoming the regulatory stamp of approval of choice whether a fund intends to launch domestically, across the EU or increasingly outside the EU to those countries which allow UCITS 3 products to be “passported” into their own countries.
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UCITS 3 In Practice
The implementation of UCITS 3 allows previously long only portfolio managers the scope to utilise “short extensions” through the use of listed and over the counter derivatives for more than simple hedging purposes. This provides managers with powers hitherto out of their reach in order to introduce greater flexibility when constructing and managing portfolios. Together with this greater flexibility come a number of important restrictions.
Most significantly, portfolio managers are not allowed to utilise “naked short positions” as part of their strategy. Neither can they short sell stock or write uncovered call options. Furthermore, they must be able to demonstrate that they have sufficient risk controls to monitor exposure to the above instruments, including the ability to monitor over the counter derivative exposure to each counterparty and must not have more than 10% of fund NAV exposed to any single counterparty in over the counter products.
Critically though, a core plank of a 130 / 30 strategy is the ability to have exposure to short positions implemented through over the counter derivative products. Equity swaps have thus far proved by far the most popular choice of product for managers seeking short exposure.
Investment rule changes: why increased flexibility matters
The single most significant benefit to traditional fund managers is the improved opportunity to make negative calls in stocks held within a portfolio which the manager suspects might underperform. In a traditional long only environment a fund is limited by the size of a stock’s weight in the benchmark index. With the advent of short extensions this limit is removed and even stocks with relatively small benchmark weights can be underweighted by shorting strategies in order to enhance overall returns. Other advantages accruing to the manager introducing leverage include the ability to achieve greater diversification amongst overweight stocks and that size bias can be removed from a portfolio.
Inevitably, the benefits associated with adding leverage do not accrue at a constant rate. Tracking error constraints must be met, even when increasing the active weight accorded stocks on a portfolio sell list. According to Citigroup, it may be necessary to reduce active weights on stocks held in a portfolio buy list and replace them with stocks in which the manager has no strong view but which may have risk benefits by,
for example, increasing diversification. The point at which the decrease in exposure to buy listed stocks will offset the increase in exposure to sell listed stocks and is regarded, by Citi, as the point of “optimal leverage”.
Inevitably, optimal leverage varies from fund to fund and depend on factors within and without the manager’s control. Tracking error is important in this context but even comparing funds with the same tracking error one still finds a wide variation in optimal leveraging levels. The most significant factor determining this variation tends to be the size of stocks appearing on a manager’s sell list. Where relatively small then the gains from leverage tend to be greater and the optimal level of leverage will be higher. The numbers of stocks held in buy lists and sell lists tend to matter too.
Other factors to consider include a manager’s ability to assess market conditions, the level of transaction costs for trading and borrowing and not to be overlooked, a manager’s relative ability to pick winners and losers. Where a manager is better at picking losers he will inevitably benefit disproportionately from the ability to introduce leverage. If a manager is better at picking winners leverage is likely to be of lesser benefit.
Conclusion: Half time in the 2007 investment match
Retail investors considering the performance of their portfolios at the end of H1 2007 have a lot to mull over. Market conditions have proved tricky enough but in addition, less onerous investment regulations enshrined in UCITS 3 have provided the scope for professional portfolio fund managers, outwith hedge fund managers, to take advantage of increased leverage in order to improve portfolio performance.
Whether this improved flexibility has actually worked remains to be seen but the physical manifestation in the equity market has been that those companies which have disappointed the market have tended to see their share prices hit disproportionately. That there has tended to be no pattern to these disappointments has turned stock market investing into a minefield across which all investors must pass. The consequence has been that whilst some investors have been lucky enough to enjoy the benefits associated with aggressive share price upside when stocks within their portfolios have been the target of both rumoured and actual bid speculation, others have seen performance severely dented by weakness in those stocks which have disappointed. As the second half of the year gets underway we would expect to see more of this disconcerting phenomenon.
By Jeremy Batstone, Director of Private Client Research at Charles Stanley
