Today’s Money Managers Are Leveraging Funds Into Alternative Investment Products

Traditionally, money managers either bought or sold. They bought the names they liked and sold the ones they didn't. Hedge funds, however, have been free to buy, sell, sell short, and use derivatives and structured products to increase yield and drive gains. Long-only managers certainly have had fewer tools at their disposal.

But today isn't like yesterday. Today, close to 70 percent of large (more than $50 billion in assets under management) traditionally long-only funds have or are developing alternative investment products (e.g., hedge fund-type leveraged funds). These funds -- typically called 120/20 or 130/30 funds -- are chartered to enable the manager to have long positions of 120 percent or 130 percent, depending upon the charter, but have offsetting short positions of 20 percent or 30 percent, respectively.

This ability to use leverage -- short the names they hate while doubling up on the positions they love -- has interesting implications. Traditional funds, while not experiencing the asset-growth rates of hedge funds, manage more than 10 times the assets of hedge funds -- by some estimates, close to $20 trillion. If these funds all were able to go significantly short, it could trigger $4 trillion worth of short sales, more than twice the total of all hedge funds' assets combined and almost equal to shorting the aggregate market cap of all 30 Dow Jones Industrials.

While (hopefully) short sales will never amount to $4 trillion, the number of short positions will increase as more fund managers employ leverage, which could create a downdraft on more-financially unsound or out-of-favor stocks. This swarm of selling would also create some nasty publicity. Think of the Overstock.com and the Utah regulatory backlash over naked short-selling -- multiplied by a factor of X. This type of corporate outcry could easily trigger a legislative and/or SEC response.

The practical nature of shorting this much stock also would be a challenge for most funds. The management of these short positions would require buy-side funds to significantly invest in technology and operations, since many traditional funds don't have the expertise or technology to book, risk manage, track margins and account for short positions. Funds also would need to borrow stock to cover these short positions. But given the scale, where would funds find the borrows?

Not all leverage, however, needs to come from short sales. Derivatives and structured products also can be employed to profit on pricing declines. But again, traditional buy-side managers would need the technology and risk management expertise to effectively manage these more-leveraged positions.

Managers also will need ideas. While many ideas will come from internal research groups, many also will come from brokers, who have been working on these strategies with hedge funds for years. This research drive will provide brokers with the ability to ration the most-promising ideas to their largest and/or most-lucrative clients. And this rationing will be a huge benefit for brokers, who will extend their profitable prime services units to their more-traditional clients, increasing fees as well as making it difficult for the buy side to effectively continue the historical downward commission march.

Now, while many funds are beginning to start 120/20s and 130/30s, these leveraged products still are small and very much in the early days. However, the writing is on the wall. A wider selection of funds, fund managers and financial products will take advantage of leverage. And while we hope never to see the entire value of the Dow Jones Industrials shorted, leverage certainly is becoming an increasingly used and valued tool for the money manager.

Larry Tabb is the founder and CEO of TABB Group, the financial markets' research and strategic advisory firm focused exclusively on capital markets. Founded in 2003 and based on the interview-based research methodology of "first-person knowledge" he developed, TABB Group ... View Full Bio