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| The Coming Hype of 130/30 Funds |
| by
Todd Trubey
| 08-07-07 |
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The so-called "130/30 fund" is new and rare enough that your clients may have yet to be introduced to the species. That said, expect that clients will 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 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. When it shorts, the fund 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. 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, 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 example, 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. 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 separately managed accounts in the institutional world. Institutional investors generally are fond of disciplined investing. They tend to construct portfolios out of investments whose beta they can measure, and which they believe will provide extra returns via stock-picking. 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.
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