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How Big Will 130/30 Be?

by Mike Trapanese

Today, around $100 billion in assets are held in 130/30 strategies. Merrill Lynch envisions the worldwide market for 130/30 funds at $1 trillion in just five years time. More ambitious, the TABB Group doubles the estimate to $2 trillion and claims that 2 years should do the trick. Looking at recent growth, neither of these figures sounds outright unrealistic.

Research from Macquarie Capital Markets (Empirical Analysis on Active Extension Strategies, April 2008) shows that relaxing the long-only restriction can raise the transfer coefficient of a fund, thus increasing its information ratio and boosting excess returns. In an alpha-crazed environment, this helps to explain the 130/30 hype. As mainstream investors pour into long/short strategies, however, the cost profile of short trading is bound to change.

Short positions require borrowed securities. For an asset manager, a prime broker will locate lenders and facilitate an exchange. There is a natural limit to the number of shares on short offer, however, and this quantity is necessarily far less than the number of long shares on the market. Growth in 130/30, along with other long/short hedge fund strategies, will increase demand for borrowed shares and drive up the cost of borrowing them. Scarcity will enable both lenders and prime brokers to increase fees, eating away net returns.

At a recent NICSA conference, I heard a prime broker put a great deal of faith in his firm's ability to rehypothecate shares, effectively stretching the number of short shares currently available. When he was asked if $1 trillion was realistic, his answer was telling: "maybe."

Short trading will undoubtedly play a role in future fund innovations. In estimating the future market, however, we must be cognizant of the limitations of our current one.