May 2008

PERFORMANCE: Adding Alpha

Fidelity has the research resources and has the track record to show that its proprietary research adds value. Niklas Tell comments ...

Fidelity might be best known as a typical long-only manager, but thanks to its extensive proprietary research it has for some time also successfully managed what it calls active extension strategies.

These funds are commonly known as 130/30 funds, but Fidelity refers to the as as active extension strategies. Like other managers that run these funds,  this is because the fund is not rigidly 130/30 but alter its net market exposure. Fidelity’s European fund can, for example, move within a range of 45% and 135% net market exposure, even if it is more likely to be between 90-110%.

We have covered 130/30 funds before in this column and in the March 2008 issue, Funds Europe covered the topic in a story named “Long-only managers stand tall in the short-selling space”. In that article Clark Cheng, head of US research in the alternative investment group at HSBC Private Bank said: “The skill of shorting securities is key to the success of a 130/30 fund manager, yet few practitioners can provide evidence of their proficiency”.

The same arguments were highlighted at the premiere of the Nordic Fund Selection Forum, a conference for invited fund analysts and fund-of-fund managers in the Nordic region arranged by Tell Media Group. It was clear that not everyone is convinced that these products are more than a fad. Some, however, do use the products as building blocks in their portfolios and they highlight the need for the manager to have knowledge and technical know-how about  how to handle the short side.

As we wrote when we last covered 130/30 funds, the design, or concept if you will, is straightforward enough and easy to like. Fidelity says that the problem with long-only funds is that managers cannot effectively exercise their negative views.

These funds can therefore be seen as the third step in the development of equity funds. First there are funds that are managed close to its benchmark, ie low tracking-error products. The problem with these offerings is that they are not excellent for capturing positive ideas and they of course do not capture negative ideas. The second step is the so called ‘high-alpha’ funds, which by definition are high tracking-error products. The offering better captures positive ideas and is slightly better for capturing negative ideas as managers have the freedom to more aggressively underweight stocks they don’t like. The 130/30, or active extension products should, at least in theory, be better at capturing both positive and negative ideas and tracking-error does not have to be high.

But even if the blueprint makes sense in theory it is the quality of the underlying investment process that will determine the outcome. Fidelity has the research resources and has the track record to show that its proprietary research, both buy as well as sell recommendations, add value. This is, of course, key to successfully managing these new products. Not even that is enough though. Fidelity says a manager needs both an abundance of negative views (which are obtained from the research department), but maybe just as importantly, short positions that are not crowded are also needed. It should therefore not come as a surprise that Fidelity’s offering in this space has a dedicated short-side analyst who assists the fund managers. Maybe that’s what is needed for long-only managers to stand tall in the short-selling space.

Niklas Tell is a partner at Tell Media Group AB
© 2008 funds europe