How 130/30 Funds Work
The mechanics underlying such funds explain the curious name. Firs
t and foremost, the fund's assets are split into two parts: a long portfolio and a short portfolio. Most investors understand what a long portfolio is. When a fund buys shares in a company that it expects to appreciate, it is said to be "long” those shares. 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.
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 believe that a long-only structure is restrictive as they are prevented from making money by targeting unattractive securities.
There are already plenty of long-short funds in existence, but the 130/30 structure has another attraction over other types of long-short portfolios, at least according 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 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 31 July 2007, the typical long-short fund has gained an annualised 5.3% in Sterling terms—far below returns offered by major equity indices. With a 130/30 fund, fund marketers 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? The reason that most of these funds hover around 130/30 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, 130/30 investing is most prevalent in the institutional world, specifically in separately managed accounts--which are like funds but are not governed by the same investment regulations. Institutional investors 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 and JP Morgan for example. More than half of these 40 accounts started in 2006; only a handful operated before 2004. One might also guess that the strategy is commonplace in hedge funds, but it's not.
While there aren't many 130/30 retail funds yet, we think a lot of them will be here soon. UBS offers a US focused version, called UBS US 130/30 Equity and F&C has announced they are launching a UK-focused offering, F&C Enhanced Alpha UK Equity.
What Do Investors Need to Know About 130/30 Funds?
We think that as with most types of funds, there will be some superior offerings. For instance, we find the UBS offering intriguing given the management team’s low-key approach and strong record with their long-only funds. But we’re not sold entirely on the concept. 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. With 130/30 funds, stock-picking is even more important, as managers must correctly pick shares that will go down and shares that will go up. This creates the possibility that if the manager fares poorly on both fronts, the fund could suffer much more than he would at a long-only offering.
In short, 130/30 funds sound good in theory, but they are extremely dependent on the stock-picking skill of the manager and carry potentially greater risks than long-only funds. Until we see clearer evidence that they can consistently add value over the latter, we don’t think there’s a compelling reason to include them in portfolios.
