The strategy of a short-enabled fund dares not speak (or even know) its name.

    Over the past five years, institutional investors have taken quite a shine to a type of fund that nobody quite knows what to call. At last count, pensions and endowments had committed some $30 billion to these so-called "short-enabled," "short extension," "120/20" or "130/30" portfolios. One thing is certain: The trajectory in asset commitments is steep and upward. According to Pensions & Investments (May 14, 2007), short extension assets grew 1,129% in the first five months of 2007 alone. Three dozen managers now claim to offer short-enabled plays to institutions.

Now the proliferation is spilling over into the retail space. Nearly a dozen money management firms are preparing to launch or have already floated short-enabled mutual funds of their own. In the past year, a quarter of a billion dollars has been rolled into the first four funds adopting a short extension structure.

So what makes these funds so popular?

It's simple, really. Boosters believe that a short extension framework can enhance returns without adding significant risk.
How so? Well, to understand that, you have to know a little something about how these funds work.

Suppose we look at a fund using a 120/20 structure. The portfolio manager invests $100 in undervalued stocks from a basket, such as the Standard & Poor's 500 index, then shorts $20 in stocks from the pool that are deemed overvalued. Proceeds from the short sale are used to purchase an additional $20 of undervalued issues. Thus, the manager ends up with $120 invested in long positions and $20 in short positions. That's where the 120/20 moniker comes from. In a nutshell, the long side is levered by short sales, allowing $140 to be invested for every $100 brought under management.
Short-enabled strategies gained traction after Roger Clarke, Harindra de Silva and Steven Sapra of Los Angeles-based Analytic Investors published a number of research papers describing the effect of constraints-most particularly a "long-only" mandate-on portfolio efficiency.

Analytic researchers found that long-only portfolios leave a lot of alpha untapped. A manager may rank-from overvalued to undervalued-all the stocks in an investable universe, but if he isn't allowed to sell short, a lot of that information is just tossed aside. Stuck with a long-only constraint, a manager is forced to seek value solely from market outperformers. This, not surprisingly, is tough since, historically, more stocks have lagged the S&P 500 than have beaten it. A long-only mandate effectively turns off an alpha spigot.

A manager who can't significantly underweight the stocks he thinks are basement-bound, at best, can only shun ownership. About 80% of the stocks in the S&P 500 represent very small-a half-percent or less-weightings in the index. That leaves the long-only manager discretion to underweight such issues by as much as, but no more than, a half-percent. Relaxing the long-only constraint allows the manager to meaningfully increase his commitment to a negative view, e.g., to a 1% or 2% underweight or more.

As Analytic Investor portfolio manager Dennis Bein puts it, "Portfolio management is like golf. You can have 14 clubs in your bag, but if you're a long-only manager you're restricted to only using six or seven of them. A long/short portfolio really has all of them to choose from. I'll take my shot with 14 clubs any day."

Despite the short selling, the short-enabled portfolio maintains a market exposure equivalent to that of a traditional long-only fund (120% long + 20% short = 100% net long). This is quite unlike market-neutral or hedged equity funds that attempt to reduce a portfolio's beta correlation; the objective of short-enabled funds is beta maintenance of around 1.00.
With all this in mind, there are some important questions to ponder when considering the utility of short-enabled funds.

Are They Better?

Whether a short-enabled fund is better than a traditional long-only portfolio depends on the client's requirements. If the client is looking for a clearly defined-and benchmarked-market exposure, wants an alpha kicker and is willing to absorb a modest amount of active risk, then yes, a short-enabled portfolio may be better.

That's a big may, mind you. Keep in mind that a 130/30 or 120/20 structure is just that-a structure, not a strategy itself. The manager's proprietary stock selection methodology must still be relied on to pick the right stocks-short and long-to earn alpha. Relaxation of the long-only constraint simply makes it possible for more of the manager's ideas to find expression in the portfolio, for better or worse. The adage "garbage in, garbage out" holds true for asset management just as it does for computer programming.

There's no shortage of debate on the merits of short-enabled portfolios. Morningstar's Fund Spy analyst Todd Trubey takes a rather dim view, recently expostulating, "While the overall behavior of one of these funds may be very similar to long-only peers, we believe that there are unusual risks involved that don't show up in the statistics. For that reason, we expect that a lot of these funds will be quite disappointing, with their short stakes actually dragging their returns below what you could derive from a passive index fund that has no benchmark risk."

New empirical data, however, challenges Trubey's contention. According to a study set for publication in the Journal of Alternative Investments, short-enabled funds would have outperformed equivalent long-only portfolios over the last dozen years. Gordon Johnson, a portfolio manager with Lee Munder Capital Group, authored the study and says, "Our research shows that with a reasonable alpha model, 130/30 portfolios stand a very good chance of outperforming their long-only counterparts. This holds true in a large-cap international universe just as in a domestic universe. However, our results also show that there will likely be years where the shorts in a 130/30, measured in simple terms by themselves, may not add value. In the long run, however, an investor in a 130/30 portfolio is likely to do better than an investor in a corresponding long-only portfolio."

What Can I Expect From Them?

First, consider tracking error. Analytic's objective for its Old Mutual Analytic U.S. Long/Short portfolios is to exceed the return on the S&P 500 by 250 to 400 basis points (2.5% to 4%) annually with volatility no greater than that of the benchmark. Likewise, UBS managers expect their U.S. Equity Alpha portfolios' volatility to match that of the market while outdoing their Russell 1000 benchmark by 250 to 500 basis points annually.

Next, consider the size of the short extension. Analytic's seminal research found that just 20% to 30% of short selling was needed to enhance alpha generation. This has since become the sweet spot for short extensions, though current research indicates that market conditions, for the most part, dictate the optimal long/short ratio. Under certain conditions, the best mix might be 110/10; in another scenario, 150/50 may be better.
There's an inherent check on the size of a mutual fund's short side, however. Mutual funds' use of leverage is statutorily limited, so you're not likely to see the sometimes-large extensions possible in portfolios not subject to the Investment Company Act of 1940.

In the future, short-enabled portfolios are likely to be more "active" in the sense that the long/short ratio may vary in response to changing market conditions rather than remaining fixed.

What Do They Cost?

Short-enabled funds carry higher expense ratios than traditional long-only portfolios. With annual expenses averaging 2% or more, it's a good idea to ask what the client gets for such costs. Dividing a fund's alpha by its expense ratio gives you a benefit-to-cost ratio that can be used to compare funds side by side. A ratio above 1.00-reflecting risk-adjusted returns in excess of costs-is ideal.

Don't forget the effect of sales loads on performance, either. Class A shares of short-enabled funds carry front-end sales charges of 5.50% to 5.75%. These charges can eat deeply into portfolio gains or greatly magnify losses. Before sales charges, for example, retail class Old Mutual Analytic Long/Short shares (OADEX) cranked out a 20.71% annualized gain between September 27, 2006 and September 28, 2007. The sales charges slash the fund's return to 12.71% and ratchet down its benefit-to-cost ratio from 2.44 to negative 0.37.

If sales charges can't be waived, Class C shares offer an alternative. Class C shares trade front-end loads in favor of higher annual expense ratios. Figure 1 compares the expense ratios of three of the longest-lived short-enabled mutual fund portfolios.

Is The Manager Skilled?

Short-enabled mutual funds are new, so track records are short. The longest-lived short-enabled portfolio is the Old Mutual Analytic U.S. Long/Short Fund, which adopted the 120/20 fund structure in February 2006 after spending several years as a more conventional long-only product.

Although the fund may be untested, the fund manager isn't. The subadvisor for Old Mutual's fund is Analytic Investors-the pioneer of the short-enabled world. Analytic launched the first institutional 120/20 portfolio five years ago.

A portfolio manager's institutional track record should be examined to get an idea of his long-term success running a short-enabled portfolio. Keep cost differentials in mind, though. Institutional portfolios have much lower expense loads than retail funds, so institutional performance may overstate the potential returns available to individual investors. The track record of Analytic's institutional Core Equity Plus (120/20) strategy, managed by Dennis Bein, can be found at:

Of course, there's no better indicator of a mutual fund manager's skill than mutual fund performance numbers themselves. Figures 2 and 3, page 102, depict three short-enabled mutual funds with year-long track records. The winner in the derby is clearly the Analytic-managed Old Mutual portfolio. Despite its outsized expense ratio, OCDEX's benefit-to-cost ratio outgunned not only that of its peers but also that of the low-cost Vanguard 500 Index Fund.

Where Do They Belong?

To determine if these funds are appropriate for a client portfolio, keep the funds' benchmarks in mind. Most short-enabled funds occupy the large-cap space since big stocks are typically the most liquid and easiest to borrow. Not surprisingly, these funds are mostly benchmarked to the S&P 500. That said, existing short-enabled funds are most appropriate as part of, or replacements for, a client's large-cap exposure. Newer funds, however, include those benchmarked to large-cap growth and international indexes.

Where Do I Find Them?

Don't expect to get much help from fund trackers like Morningstar or Lipper when searching for short-enabled funds. Morningstar only recently created a long-short category into which absolute-return portfolios, market-neutral funds, managed futures and hedged equity are thrown. Short-enabled funds are excluded. The firm's database, instead, lumps short-enabled portfolios into the large-blend category. There's a certain degree of intuitive sense in this as the oldest 130/30 and 120/20 funds hug the large-cap core benchmarks, but the extra digging involved to determine which of the hundreds of portfolios in the category have relaxed the long-only constraint is off-putting.

For its part, Lipper's database includes short-enabled funds in its long/short equity classification. This, at least, limits the amount of sifting that must be done to find 130/30- or 120/20-structured products.

Only a handful of short-enabled mutual funds are available now, but several are stacked up in registration.

"Established" funds-those launched at least 12 months ago-include Old Mutual Analytic Long/Short (OADEX), UBS U.S. Equity Alpha (BEAAX), ING 130/30 Fundamental Research (IOTAX), GS Structured U.S. Equity Flex (GFEAX) and GS Structured International Equity Flex (GAFLX).
"New" funds-those launched or converted within the past few months-include IXIS Westpeak 130/30 Growth (NEFCX), Mainstay 130/30 Growth (MYGAX), Mainstay 130/30 Core (MYCTX) and Mainstay 130/30 International (MYITX).
Funds in registration at this writing include Blackrock Large Cap Core Plus, Dreyfus Premier 130/30 Large Cap Growth and SSgA Core Edge Equity.

Time Will Tell

Only time will tell if short-enabled mutual funds live up to the expectations of their creators or are, as some critics contend, a mistake in the making. The costs attached to short-enabled funds are especially critical, but, as we've seen, can still be trumped by skillful stock picking. An experienced advisor shouldn't be afraid to consider these funds, but may wish to carefully evaluate how well they fit into existing asset allocations and risk tolerances, keeping in mind Oscar Wilde's admonition: "Experience is the name every one gives to their mistakes." 

Brad Zigler formerly served as head of marketing, education and research for the Pacific Exchange and Barclays Global Investors.