The Bloom Is Off 130/30 Funds

When 130/30 funds first came out, I was amused by the ideas I heard from reporters and a few investors that these funds would be good for choppy or down markets because they have long and short positions. True they do have shorts, I pointed out, but they're still 100% long whereas the typical equity fund is 95% long and 5% cash. It's an interesting idea, but don't look for a free lunch, was my response.

So, I'm not surprised that 130/30 funds as well as 120/20 funds are down like the rest of the world this year. But I am surprised by just how gosh darn bad they've been.

For background, 130/30 funds are funds that use leverage to have long positions equal to 130% of assets and shorts equal to 30%. The idea is that the manager is able to take advantage of research that indicates a stock is overpriced as well as stocks that are underpriced. Essentially you are leveraging up your bet on a manager's ability to add value though taking on only a bit more market risk than with a regular fund. The tricky part is that the manager has to be quite good at both longs and shorts to make it work.

And from the looks of it, not many managers have been able to add value in this strategy this year. Of the 18 leveraged net long (our phrase that encompasses 130/30 and 120/20 funds) funds only three are ahead of their category benchmark for the year to date. Most are down much more than the S&P 500's 35% year-to-date loss. Consider RiverSource Contrarian Equity 120/20  is down 46% and RiverSource 130/30 US Equity  is down 42%. RidgeWorth International Equity 130/30  is down 58% or 800 basis points worse than MSCI EAFE thus showing 130/30 funds can do just as poorly overseas as here in the U.S. (RiverSource 130/30 U.S. Equity's managers just bolted for Putnam and the firm hasn't decided what's to become of the fund.)

Fidelity's new 130/30 Large Cap fund  is having a brutal start, too. It's down 29% in just three months which is about 600 basis points worse than the S&P 500.

What's Gone Wrong?
Having leverage and 100% net long exposure is a tough place to be in a bear market. Beyond that, it's clear that 130/30 managers are flailing around just like the rest of the managers. It would have been great if they'd had the insight to short the banks and other stocks that have been crushed and to go long on health care and the other stronger stocks, but that's not easy. Moreover, if I'm going to make a big bet on a manager's stock-selection skills, I'm going to pick one of the best with a proven record. There are some good managers running 130/30 funds but no real all-stars, which is why we don't have any 130/30 funds among our Fund Analyst Picks.

One Fund that Got It Right
There is one standout, though. MainStay 130/30 high yield  is down 16%. That's not pretty--but it's 1,000 basis points better than the index and beats nearly all high-yield funds. It's worth noting that MainStay's long-only portfolio has also outperformed though not quite as much as this one. Thus, it's not the magic of the 130/30 format, but rather managers making good calls that really matters. Managers Dan Roberts, Louis Cohen, Michael Kimble, and Taylor Wagenseil correctly saw that consumer discretionary issuers were especially vulnerable and instead invested in aerospace, energy, and specialty chemicals. They also shorted consumer dependent junk bonds from Nordstrom, Royal Caribbean, and Mexican homebuilder Homex. That helped the 130/30 fund lose less than their long fund.

Also noteworthy is that they say the managers have been shorting bonds since the 1980s. You want that kind of expertise in a 130/30 fund because shorting is a different beast. Some 130/30 funds have those kinds of managers but at others I get the sense that it's kind of new.

Interestingly, they now have taken shorts down so that they are about 115/15. They say that with the high-yield market on its back the risk of shorts has increased and even some of the consumer dependent bonds look cheap now. In addition, they say hedge funds have piled into the short side because of the new restrictions on shorting stocks.

By the way, that success hasn't spread to Mainstay's 130/30 equity funds, all three of which lag their benchmark.

What's Next?
About 10 years ago, market-neutral funds were fresh and new. Many quickly proved to produce negative returns in any kind of market rather and they were quickly liquidated or merged away. I would imagine those 130/30 funds that are well behind their index have a rather brief time period in which to right the ship before being merged away.

More broadly, I doubt these funds will be able to draw much money (Mainstay's sole exception noted) now that it's clear there's no free lunch to be had.

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