As these strategies all have shorting and leverage in common, plan sponsors must deal with a variety of issues when selecting an investment manager to implement them.
Manager skill – While each strategy provides investment managers with an increased opportunity set, the plan sponsor must be confident that the manager has the necessary skills to take advantage of these opportunities. When evaluating investment managers, it is important to have a strong understanding of the manager’s competitive advantage. Is there a superstar manager involved or a team approach to research? Additionally, does the manager have the resources to research a large number of investment opportunities on both the long and short side?
Risk management – The application of all three strategies requires significant due diligence from the plan sponsor and the investment manager. In evaluating the investment manager’s risk management processes, plan sponsors should ask questions such as, what risks are measured, and how is risk managed? Does the firm have a dedicated risk management department? If not, how does it separate risk management from investment management? Who are the firm’s outside providers—for example, its independent auditor, legal counsel and prime broker?
Once an investment manager is hired, the plan sponsor needs to ensure that due diligence is ongoing. This includes reviewing the stability of the firm and personnel, the investment performance and, most important, how the portfolio is being managed. For instance, neither 130/30 nor market neutral strategies are fulfilling their mandates if they have a net market exposure equal to 50%.
Fees – Fees for alternative equity strategies can be significantly higher than for long-only mandates. Generally speaking, fees will include a base fee plus a performance fee. Plan sponsors should review returns net of all fees to ensure that their objectives are being met and that risks are adequately compensated.
Important issues to consider in evaluating performance fee structures include whether or not there is a high water mark (the highest value that a fund has achieved, below which performance fees should not be charged) and what benchmark performance fees are calculated against (cash or an equity benchmark).
Liquidity – Plan sponsors should closely review all legal agreements to know their rights when redeeming assets, including the notification period. For example, can redemptions be restricted? Is there a penalty for early redemption?
Each of these alternative strategies provides investment managers with an increased opportunity set relative to the traditional long-only mandate. The plan sponsor benefits from greater return potential and the opportunity to add strategies with low correlations to the overall movements of equity markets. That said, the key to successful investing has not changed: it still takes a skilled investment manager to outperform a benchmark and add value after fees.
Short-selling
The mantra of successful long-only investing is to buy low and sell high. In contrast, short-selling allows an investment manager to sell a stock that the manager doesn’t actually own. In essence, the manager is trying to sell high and buy low.
To facilitate a short sale, the investment manager must borrow the stock from another investor and provide collateral to the lender as security. If the manager’s research is correct, the stock will drop in price. The manager can then purchase it back at a lower price and return it to the lender.
Leverage
It is important to consider not only the amount of leverage employed, but also how the leverage is used in portfolio construction. Strong risk management procedures will ensure that investment managers consider both their gross and net market exposures.
Gross market exposure is essentially how many times $1 is being invested. Net market exposure considers how a portfolio is designed and how the positions offset one another. Figure 3 summarizes the gross and net market exposures of each strategy.
Jason Campbell is an investment consultant in the Toronto office of Eckler Ltd. jcampbell@eckler.ca
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