130/30 Funds - Hedge Like the Big Boys?
Your mutual funds and ETFs are flagging. The 401(k) balance is dropping almost daily. Surely there’s a way for you to align your investment strategy to counteract these trends, right? Well, once again Wall Street comes to the rescue. There’s a new fad rippling through the mutual fund industry - the 130/30 fund. Is this the common man’s hedge fund or just another money-losing gimmick?
The 130/30 Fund
So what the heck is a 130/30 fund? It’s a mutual fund that is ‘long’ 130% of net assets and ’short’ 30%. (An investor is ‘long’ a stock if he/she has purchased it in the hopes that the price will increase; a ’short’ is when the investor is hoping the price will decrease.)
That adds up to 160%; how, you ask, do they own 160% of net assets. The short answer (no pun intended) is that the short position and part of the long position kind of cancel each other out. It works like this. When you short a stock, you borrow the shares and sell them into the market. That nets you cash. A 130/30 fund takes those proceeds from the short sale and reinvests them ‘long.’
Confused? Don’t be. In simpler terms, what a 130/30 is doing is just using leverage.
The idea behind the 130/30 fund is an alluring one. By intelligently choosing which stocks to short and which to hold long positions in, you hedge against adverse price movements. Just like the big boys at the hedge funds do!
Is a 130/30 fund for you?
Likely not. There are a couple of serious negatives to 130/30 funds.
First, they’re actively managed funds. As we all know by now, actively managed funds never beat index funds over the long term. They can’t - no advisor gets it right all the time. Statistically speaking, you’re much worse off in actively managed funds. Besides that, actively managed funds have higher expenses than index funds. Expenses are one of the few ways you can truly influence your investment returns.
It’s even worse than that, though. The second reason 130/30 funds are a bad idea is that their expenses are likely to be even higher than other actively managed funds for a couple of reasons. First, when you short a stock, you have to pay dividends to the person you borrowed the security from in the first place. Second, there are additional trading expenses associated with the ‘extra’ 60% of assets.
Another reason you probably don’t want to own a 130/30 fund is their whole reason for being - leverage. As people learned in the recent real estate crash, leverage is great when prices are going up but murder when they’re going down. Boiled to its essentials, what a 130/30 fund is doing is really just borrowing money to leverage up their exposure. This is a way of end-running the mutual fund prohibition against buying on margin.
Though the idea is nice, I’ll personally be staying away from 130/30 funds. But then again, I don’t invest in anything but index funds and ETFs, so I’m not exactly their target audience.
This article published only at Advanced Personal Finance.
May 2nd, 2008 at 11:35 am
Good post and synopsis. I agree these funds aren’t great choices for most investors. I think that a lot of “newer” investors try to do the complicated things with their portfolio’s because the pro’s do.
What people fail to realize, initially, is that a lot of “pros” don’t get the media attention they deserve, like the state pension funds that using index funds as their core holdings for example.
It’s also difficult to judge the risk of this type of investment, and people often forget that leverage can magnify the gains and losses.
And while we’re on the topic of index funds, if you have a free moment check out my post below on some “index” fund wannabe’s.
http://harvestingdollars.com/2008/05/02/not-all-%e2%80%9cindex-funds-are-the-same/
May 2nd, 2008 at 8:17 pm
I don’t think this is a great time to be investing in any kind of leveraged funds. The fact that this can even be pitched to ordinary investors in this financial environment is proof of Barnum’s Law. I think the worst time to shuffle your 401k into risky investments is when it is losing money. That’s a strategy for losing all the money you have instead of just lots of the money you have. Thanks for a good article that makes sense of 130/30 funds in a clear and concise way.