What Are 130/30 Funds?
The Basics of 130/30 Funds
130/30 funds are revolutionary -- or so say the marketers who explain the funds as a way to take advantage of the fund managers' stock picking expertise. What are these 130/30 funds and should you buy one?
Traditional Funds vs. 130/30 Funds
The traditional equity mutual fund owns the stocks the fund manager believes will outperform compared to the fund’s benchmark. In other words, the fund manager might buy shares of Microsoft because he/she believes that Microsoft will outperform a domestic large-cap equity index -- such as the S&P 500.
If this same manager decides that Microsoft is a lousy investment, the manager can only sell the stock if they currently own it.
Therein lies the difference between a traditional mutual fund and a 130/30 fund. If the manager of a 130/30 fund believes Microsoft is a lousy investment, they can sell the stock short. In other words, they can sell the stock without owning the stock -- a strategy that investors can use to take advantage of a falling stock price. So, a manager of a 130/30 fund can make a decision to buy a stock in order to make money and sell a stock to make money (versus the traditional fund manager that can only sell a stock to not lose money).
Structure of 130/30 Funds
A 130/30 fund will be long (own) stocks worth 130% of the portfolio while shorting (such as in the above example with Microsoft) 30% of investor assets in the fund.
Let’s look at a simple example to understand the concept of 130/30 funds:
- The fund has $1 million of assets for which it buys $1 million of securities (100% long).
- The fund borrows securities worth $300,000 and sells those securities (30% short).
- The proceeds from the short-sales are used to buy $300,000 additional securities (30% long).
- The fund has $1.3 million securities long (130% long) while shorting $300,000 (30% short).
- Now we have a 130/30 fund.
The Attraction of 130/30 Funds
The 130/30 fund structure is particularly interesting to the active fund manager who believes he/she adds value by picking and choosing individual stocks. For instance, the traditional fund manager can choose stocks that they believe will increase in value -- investing 100% of the portfolio in their stock selections. On the other hand, a fund manager of a 130/30 fund also has 100% exposure to the market but makes investment decisions with 160% of portfolio’s assets.
How do they achieve 100% exposure to the market and make investment decisions with 160% of the portfolio’s assets? As in the example above, the fund manager decides to buy stocks worth a total of 130% of the fund’s assets and decides to short stocks worth 30% of the funds’ assets. The fund exposure to the market is 130% positive and 30% negative which nets to 100% and he/she has made active decisions totaling 160% of the portfolio (130% long, 30% short).
The Risks of 130/30 Funds
Who better to define the risks of a 130/30 fund than a fund company that employs the structure? From JP Morgan Asset Management’s website: “There is no guarantee that the use of long and short positions will succeed in limiting the fund's exposure to domestic stock market movements, capitalization, sector-swings or other risk factors.
Investment in a portfolio involved in long and short selling may have higher portfolio turnover rates. This will likely result in additional tax consequences. Short selling involves certain risks, including additional costs associated with covering short positions and a possibility of unlimited loss on certain short sale positions.”
Do You Need a 130/30 Funds?
So, who really needs a 130/30 fund? Is this 130/30 fund structure more hype and hoopla for purveyors of mutual funds?
In short, 130/30 funds are in their infancy stage. While several 130/30 funds were established in 2004, the majority of 130/30 funds have less than a five year track record. It’s too early to tell.
However, if you’re a believer in index fund investing (or passively managed investing), you would balk at owning these 130/30 funds.
Getting the longs and shorts both right, would be a miracle -- an indexer might lament.