130/30 Fund Strategies
As the popularity of hedge fund strategies increases, the influence of these strategies in the traditional mutual fund world continues to grow. Once limited to only high net worth accredited individuals or institutional investors, many hedge fund strategies are now be deployed within mutual funds.
130/30 funds are one of these new mutual fund structures. The 130/30 structure differs from traditional mutual funds because the strategy allows managers to have both long and short exposure.
Most mutual fund managers can only have long positions. In a long only portfolio, managers purchase stocks in expectation of future appreciation. The 130/30 structure, allows managers to have short positions. When a managers shorts a stock, the manager is expecting to profit from a decrease in the stock value. To execute a short, the manager borrows the stock shares and then sells these shares in the open market. The manager expects to profit after buying back these shares at a lower market price.
The 130/30 number refer to the amount of long and short exposure. In a 130/30 fund, the manager has a 130% long position and 30% short position. When the manager shorts 30% of the portfolio, the manager borrows shares and immediately sells these shares in the open market. The cash generated by this sale is used to increase the long exposure by 30%. The fund thus has a 130% long position and a 30% short position.
The 130/30 structure also results in 100% market exposure. Because 130% of the portfolio is postive exposure (long positions) and 30% of the portfolio is negative exposure (short positions) the net exposure is 100%. This 100% exposure means that the fund should have similar performance to a long only fund.
Potential 130/30 Benefits
The central benefit of the 130/30 structure is the ability of the manager to short stocks and the potential benefits of leverage. One limitation of long only mutual funds is that managers are unable to act on all research. If managers find investments that managers believe will have poor future performance, the managers cannot act on this information because of the long only restriction. The 130/30 structure allows managers to make money by shorting unattractive stocks.
Another potential benefit is the use of leverage. The 130/30 structure allows $160 to be invested for every $100 of investor monies. This provides the potential for increased returns.
Potential 130/30 Drawbacks
The 130/30 structure also has drawbacks. First, the benefit of short position exposure can also be a drawback if the investment manager is a poor stock picker. The 130/30 structure enhances the influence of the managers stock picking ability on overall performance. Historically, finding an active manager that can outperform the benchmark over the long run has been very difficult. Some suggest that the most talented 130/30 managers manage hedge funds to take advantage of higher compensation and reduced regulation, leaving a less talented pool of managers to run these mutual funds.
In addition, short positions are traditionally more difficult to manage then long positions. The maximum gain from a short position is 100% if the shorted stock would go bankrupt. The maximum gain from a long position is infinite.
Another drawback is tax inefficiency. Many 130/30 funds are characterized by frequent trading, which decreases tax efficiency because of increased capital gains. Short positions are also not tax efficient.
Last, many 130/30 funds have high expense ratios. Some of these funds also have front loads. Expenses are a very critical component of long term performance.
Cartoon by Sandy Huffaker
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