In 1994, Ted Aronson faced the daunting task of rebuilding his fund management company. His founding partner's recent departure, and resulting losses of USD $400million in assets and half the firm's clients, had erased much of the gains from a decade of hard work.
Undeterred, Ted renamed the company Aronson + Johnson + Ortiz, and employed a change in strategy, introducing the firm's first actively managed long-short portfolio. The move proved highly successful, with nearly 30% of total assets under management (AUM) invested in the long-short strategy after one year, and total assets growing to over USD $14 billion by 2003. INSEAD's Rothschild Chaired Professor of Banking, Bernard Dumas and Professor Craig Ruff of Georgia State University look at A+J+O's business model to illustrate the dynamics of active investment and evaluate changes over traditional models of investment.
A+J+O is one of a new breed of asset managers. Staff and client numbers are small, with fewer than 30 employees and less than 100 clients, but assets under management exceed USD $14 billion, since accounts are typically large institutional endowments. Among the range of products offered by A+J+O, their actively managed long-short fund is one of the most successful.
The goal of active management is achieving absolute returns, as opposed to the traditional objective of performance relative to benchmarks, representing a paradigm shift toward more sophisticated investment strategies commonly associated with hedge funds. Long-short portfolios are structured as follows: for every USD $100 in assets, A+J+O invests $100 in long equity positions, $100 in short equity, and invests the proceeds from the short sale in cash positions, creating a fund which is 'dollar neutral' with a leverage ratio of 2:1.
This involves an accompanying change in analytical metrics used as well, as attention shifts from simple benchmarked performance, to focus on risk-adjusted return and creation of alpha (i.e. excess returns), now available bi-directionally through long and short investment.
While absolute gains benefit investors, they only impact A+J+O's own profitability indirectly. The cost structure of A+J+O's business model is critical for overall profitability, and is closely tied to methods of trade selection and execution. Stocks are selected through a process where value, management performance and momentum are assessed through statistical modeling. This provides a cost-efficient method of stock selection, where proprietary statistical analysis reduces research expenses frequently incurred by other investment houses.
While some companies partake in 'soft dollar' arrangements, where 'complimentary' research is gained in exchange for steering brokerage commissions to major banks, Aronson has vowed 'we have never used, and will never use, soft dollars', instead selecting brokers with only the client's best interests in mind. Soft dollar arrangements also enable fund companies to hide research expenses during financial reporting, artificially reducing management expense ratios.
Another major expense involves trading costs, which can amount to as much as 4.5% for small cap trades each way. This cuts into margins significantly, creating a situation where positions must gain almost 300bps just to break even. A+J+O has considered cost savings here, assessing 3 forms of trading, traditional brokers, electronic communication networks (ECNs) and packaged trading. Economy of scale benefits do not apply here, as size increases cost through reducing liquidity, leading many managers to 'cap' funds, declining new investment once asset value thresholds are reached.
This case study examines the new paradigm of active fund management, illustrating practicalities of long-short investment and evaluating A+J+O's business model to address factors that are critical for profitability. Hot topics in the industry are covered, including the soft dollar controversy, the paradox of size, alpha portability, benchmarking challenges and some leading thinking on where the industry is headed in upcoming years.