Borrowing hedge fund strategies

The adoption of the UCITS III directive has given long-only fund managers increased investment powers. Among them are a number of strategies that originated in the hedge fund world, including shorting, pair trading, gearing and the use of options and derivatives.

The BlackRock UK Absolute Alpha fund was launched in April 2005 with the intention of using the full range of UCITS powers to deliver absolute returns. These include shorting and pair trading, although unlike 130/30 funds it does not use gearing.

“We are using the powers very widely,” says Mark Lyttleton, the fund’s manager.

“This UCITS stuff has been around a long time. The majority of people doing it are in the 130/30 space – what I call long extension. However UCITS III powers also allow returns which are uncorrelated.”

Richard Lloyd, head of structured investments and manager of the Schroder Income Maximiser fund, says Schroders was keen to utilise some of its wider experience, including protected products.

“It was clear to us that there was demand for an equity income product, and that all the others were doing pretty much the same thing. We’re different.”

The fund uses another strategy borrowed from hedge funds, covered call options, using the option premium as a way of generating additional income from the portfolio. Lloyd says that this approach puts the fund at the lower end of the risk spectrum; the biggest risk is missing out on any upside above the call option strike price. Nick Purves, manager of the Schroder Income fund, selects stocks for the portfolio using his normal stock selection process. Lloyd and his team are then responsible for applying an additional call option overlay on those stocks.

Another example of the adoption of hedge-type strategies is the 130/30 fund. Unlike traditional long-only portfolios these funds can short-sell securities representing 30% of the portfolio’s net asset value, then use that revenue to acquire additional long positions, giving a total exposure of 130% long and 30% short.

Matthew Cox, who will run UBS’s UK 130/30 fund, to be launched in early 2008, says the strategy is a logical extension of long only.

“As part of our long only strategy we already identify undervalued and overvalued stocks. It’s a pretty natural step to make use of these overvalued stocks. It’s not always the case, though, that the most overvalued stocks make the most ideal shorts.”

Shorting stocks requires a different discipline, in Lyttleton’s view.

“If I found companies which were not interesting, previously I discarded them. Now I have to look more closely. The investment universe has widened dramatically. It’s a very pure form of investment.”

The BlackRock fund also uses pair trades, another strategy borrowed from hedge funds.

“We keep the pairs quite tight – we keep them sector and market neutral,” says Lyttleton. “The idea is that one share is going to do a lot better than the other share. As a long only manager I’ve effectively been doing this my whole career, but shorting is a different skill. Not every fund manager is interested in or suited to shorting.”

Despite the fact these funds incorporate some hedge fund techniques, Cox stresses that this does not mean they are more risky.

“These are not necessarily a big step up in risk. Clients need to get comfortable with what suits their requirements. It’s still a relative outperformance vehicle. The great thing is the flexibility. Tactics like that mean you’ve got the flexibility whatever the market conditions.”

1 January 2008