Across My Desk: For those who love long and short
Can't decide whether or not the market is going up or down? One of the latest investments to hit Wall Street is a fund called the 130/30 fund.
What follows is from a piece written in last month by Todd Trubey at Morningstar. Trubey is an analyst at Morningstar and does a terrific job of educating us all to this new breed of a long/short mutual fund.
"The so-called "130/30 fund" is new and rare enough that this article may be your introduction to the species. That said, expect to hear a lot more about it in the coming months; asset managers are starting to roll the funds out, and all signs point to an impending flurry of launches in the not-too-distant future. Supporters include some investors and plenty of marketers who breathlessly describe the 130/30 structure as a breakthrough that will revolutionize investing and amp up returns. Ultimately we think that investors should understand--but look past--the hype and bring a healthy amount of skepticism to the table when judging this group.
Nuts and Bolts
The mechanics underlying such funds explain the curious name. First and foremost, as the name suggests, the fund's assets are split into two parts: a long portfolio and a short portfolio. Most investors, even if they don't know it, understand what a long portfolio is. When a fund buys a stock that it expects to appreciate, that is buying it "long." The reverse of this, attempting to profit from a stock that drops in value, is called "selling short." When an investor sells short a stock, he borrows shares of that stock, sells them in the market, and expects (or at least hopes) to buy them back after its share price falls.
The numbers in the name of this group refer to the weightings of the long and short portfolios. That is, a 130/30 fund invests 30% of its assets in a short portfolio and 130% of its assets in a long portfolio. It runs as follows. Let's say such a fund has $1 million in investor assets. It buys a $1 million portfolio of stocks long and establishes a $300,000 short portfolio. So when one shorts, one receives cash for the just-sold shares--in this example, $300,000. The 130/30 manager will then reinvest that cash, thus adding a 30% long stake to the existing 100% long stake and the 30% short stake. And voila, a portfolio is 130% long and 30% short.
There are several reasons that this structure appeals to asset managers. First, as Bob Doll, BlackRock's vice global chief investment officer for equity, explained at the Morningstar Investment Conference in June 2007, it allows the asset manager to invest $160 for every $100 an investor devotes to the fund. Also, many investors--not only hedge-fund types but also quantitative specialists or "quants"--believe that a long-only structure is restrictive; they can make money by focusing on particularly attractive securities but they cannot make money by targeting very unattractive securities.
There are already plenty of long-short mutual funds in existence, but the 130/30 structure has another attraction over other types of long-short portfolios, at least to its practitioners. Given that it has 130% positive exposure to the market and 30% negative exposure to the market, the net result is 100% exposure to the market. So before the manager's stock picks are factored in, it should behave very much like a standard long-only fund. By contrast, most mutual funds that buy long and sell short stocks tend to have lower market sensitivity and thus are more likely to underperform when the market is rising--something that can bother many investors. For instance, over the trailing three years through July 24, 2007, the typical long-short fund has gained an annualized 6.6% while the S&P 500 has returned 13.7% annualized. With a 130/30 fund, marketing folks can say that the fund is likely to behave like the market but has the potential for higher returns via "alpha." (Alpha is broadly defined as a fund manager's ability to add value above and beyond the risk/reward profile of the fund's performance benchmark.) That's why the structure has some other names besides 130/30, including leveraged alpha, alpha extension, active extension, short extension, and so forth.
Before we move on to other matters, you might be wondering why 130/30 instead of 120/20, or 160/60? Well, first of all, due to the restrictions of funds organized under the 1940 Act, the upward limit would be 150/50--a fund using 50% leverage. The reason that most of these funds hover around 130/30, as practitioners tell us, is that below that amount of leverage, it looks like the returns aren't yet optimal, but that above that amount of leverage, the risk magnifies. To put it simply, in risk/reward turns, a 130/30 mix seems to be the sweet spot for this structure.
Who Is Running 130/30 Funds?
To date, this style of investing is most prevalent in the institutional world, specifically in separately managed accounts--which are like mutual funds but are not governed by the 1940 Investment Act. Institutional investors are those investing very large sums of money (millions or billions), typically on behalf of pensions, endowments, and so forth, and they're generally fond of disciplined investing. So they tend to construct portfolios out of investments whose market sensitivity or "beta" they can measure, and which they believe will provide extra returns via stock-picking, or "alpha." There are just short of 40 separate accounts in Morningstar's database that have some version of the 130/30 structure. Some firms running these accounts are probably familiar to mutual fund investors--UBS, JP Morgan, American Century--but others are less well-known names like AQR Capital and Ten Asset Management. More than half of these 40 accounts started in 2006; only a handful operated before 2004. One might guess that the strategy is commonplace in hedge funds, but, actually, it's not.
While there aren't many 130/30 mutual funds yet, we think a lot of them will be here soon. Only a handful exist today, including ING 130/30 Fundamental Research (IOTAX); UBS U.S. Equity Alpha (BEAAX) ;Mainstay 130/30 Growth (MYGAX); and Mainstay 130/30 Core (MYCTX).
Also, Russell has two funds that contain slices of 130/30 within them. Plenty more mutual funds, though are coming; we know of filings for Mainstay 130/30 International, Blackrock Large Cap Core Plus, Dreyfus Premier 130/30 Large Cap Growth, and SSgA Core Edge Equity.
So What Do Investors Need to Know?
We think that as with most types of funds, there will be some superior offerings. For instance, we find UBS U.S. Equity Alpha promising, largely because of manager John Leonard's low-key approach and strong record with his long-only funds. But if you're ready to run right out and buy one of these new-fangled investments, slow down. First and foremost, the 130/30 construct is not a strategy, it is a structure. In other words, you'd need to understand the stock-picking and portfolio construction approach, just as you would with a long-only fund. Plus, the main attraction of an active manager is stock-picking skill. Anyone familiar with the long-term history of active management knows that great stock-pickers are hard to find. All too often, active managers of long-only funds trail their benchmarks. So with some of these funds, we think the combination of leverage and stock-picking is likely to boost your overall returns, while in all too many funds you'll actually see the fund trail relevant benchmarks.
To put it bluntly, there is no magic or pixie dust involved here to separate these funds from their more traditional kin. They are chiefly distinguished by two things--leverage (essentially, borrowing money in an attempt to magnify gains) and shorting--which may seem nifty due to their novelty in the mutual fund world. Until the Taxpayer Relief Act of 1997, shorting was very tough to do in a mutual fund because of a 61-year old rule called the short-short rule; only 30% of a fund's gross income could come from gains on stock held less than three months, which included short sales.
Mutual funds are limited to 50% leverage, which typically has come in the form of loans (not cash from short sales). While leverage can boost an investment's positive return, it can also magnify its losses. Moreover, shorting is a difficult way to make money: Stocks, in aggregate, tend to go up over long time frames, not down. Many investors consider it a skill best left to specialists. In other words, while the overall behavior of one of these funds may be very similar to as long-only peers, we believe that there are unusual risks involved that don't show up in the statistics. For that reason, we expect that a lot of these funds will be quite disappointing, with their short stakes actually dragging their returns below what you could derive from a passive index fund that has no benchmark risk. And finally, we expect that given the special risks involved here, you're likely to see some flameouts.
One thing to keep in mind if you are considering one of these funds is the taxman. Such funds often involve significant trading, and obviously all of them involve short sales. Both of those factors drive tax inefficiency. The mutual funds are too new to be able to fully assess, but we expect them to be relatively tax-inefficient. So we'd hold such funds in tax-advantaged accounts whenever possible.
In short, 130/30 funds aren't, and never will be, an essential part of an overall diversified portfolio. Most investors should stick to their knitting by identifying and buying good, standard, traditional investments."
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