Posted by: Aaron Pressman on April 22, 2008
Christopher Holt, who used to work in the hedge fund industry, takes a stab at critiquing the critique of 130/30 mutual funds on his blog today. I’m deeply saddened he left my criticism from two weeks ago off his list. He’s citing Chuck Jaffe’s piece from April 20, which also ran in some newspapers over the past few days. If anything, Chuck’s a little too easy on 130/30 funds.
Remember the primary critique — these funds leverage themselves by selling shares short and using the cash they raise from short sales to buy more long positions. In the end, each dollar an investor puts in the fund is used by the manager to select $1.60’s worth of investments. Short or long, if the manager makes the correct selections or picks poorly, the returns will be turbo-charged by the leverage. If the long and short portfolio gains 10%, or 16 cents on the $1.60, the fund investor has gained 16% on his or her $1 deposit. But, of course, if the portfolio loses 10%, the investor is out 16%. And that’s before we even get into the down side of shorting — unlimited potential losses. Shorting can be used to hedge or limit risk, but that’s not the function in a 130/30 fund, where it’s being touted as another way for the manager to play their convictions about stock valuations.
I most strongly part company with Holt when he writes that the category of 130/30 type funds “really isn’t that different from active long-only investing. Expected outperformance or underperformance depends on the manager and strategy, not the extent of active management.” It maybe no different from long-only investors who borrow money to leverage their positions, say hedge fund managers, but it’s quite different from the typical long-only mutual fund.
I guess it’s a fair question whether fund investors should be using leverage as part of their stock market investing. I’d have to say no, it’s not an appropriate risk. The brokers that lend shares to a 130/30 manager require collateral and can demand more collateral at their discretion. Those kind of demands always come when things are going poorly. And I doubt very many fund investors quite understand the amount of leverage that’s being employed in these funds.
That’s because the real problem with 130/30 funds is the marketing gimmicktry being employed on their behalf. The supposed balancing of 30% extra long against 30% short is in theory a way to reduce market risk, or at least claim to do so. The funds are often discussed as having the same exposure to the market’s volatility, or beta, as an ordinary index fund. But it’s only true in theory. Stocks are picked based with betas calculated on historical behavior. When they eventually move in unexpected ways, the 130/30 theory blows up and you may find the fund has far more volatility than an index fund.
Holt is also perturbed that Jaffe, like I did, cites the performance record of some of the recent 130/30 mutual funds, which hasn’t been very good. He’s right that the short track records are too short to draw final conclusions but how else is an investor to gauge the appeal of 130/30 funds? A lot of the numbers flying around the brokerage community are either from invented back tests or based on funds managed by top-tier, exclusive hedge fund shops like D.E. Shaw. There’s good reason to be skeptical.
There’s one reason why these funds are becoming more popular now and that’s because the market is doing poorly and brokers are looking for something to sell that can be spun as a low-risk play in a bear market. A fund that shorts stocks yet has the same market risk as an index? Sounds great. But it’s only true in theory.
(For the view of another former hedgie who is not so positive on 130/30 funds, check out Roger Ehrenberg’s blog post from last year.)