130/30 Funds: 130% Gimmick/30% Good Idea

Attempting to ride the "alternative investment" wave of the past few years, a plethora of 130/30 mutual funds have emerged, marketed to individuals or institutions unwilling or unable to take the hedge fund plunge. Also known as short-extension funds, these 130/30 mutual funds invest around a standard equity (or bond) benchmark, such as the S&P 500, and take on leveraged positions. For example, using a $100 portfolio of stocks, stocks worth $30 are borrowed and sold short, and borrowed money is used to purchase an additional $30 in stocks, for a total of $130 in long stocks and $30 in short positions. Other versions include 120/20 funds, as most funds try to stay under the SEC's regulatory limit of 150/50, which amounts to 2:1 gross leverage.

Here's how most 130/30 fund managers describe their funds: 130/30 funds allow managers to more efficiently exploit their stock-picking skills and generate alpha by not only owning the winners but also shorting the losers. Unlike typical mutual funds, where the manager can only underweight or avoid underperforming stocks in an index, a 130/30 fund manager can short these stocks to earn a profit. Meanwhile, the investor takes the same risk as a traditional 100% long mutual fund, because the risk of shorting 30% of the portfolio is offset by taking an extra 30% long stock position. So the manager can make more profit, without taking more risk.

If that sounds too good to be true, it's because in many cases it is. The table below shows 10 different 130/30 or 120/20 funds with long-only equivalents in the same Morningstar category. In half the cases, the 130/30 fund underperformed the long-only fund, sometimes by a wide margin, such as Mainstay's 130/30 International (MYITX) and International Equity Fund . Only one 130/30 fund significantly outperformed the long-only fund: Mainstay's 130/30 High Yield  topped  High Yield Corporate Bond (MHCAX). Why did so few of these funds live up to expectations?

130/30 and Long-Only Comparison
	Category	Inception Date	Expense Ratio	Turnover (%)	Return Since 130/30 Inception
Calamos 130/30 Equity	US OE Large Growth	6/20/2008	1.98	72.0	-47.24
Calamos Growth (CVGRX)	US OE Large Growth	9/4/1990	1.21	73.9	-47.47
Dreyfus 130/30 Growth	US OE Large Growth	10/18/2007	2.76	0.0	-50.16
Dreyfus Equity Growth	US OE Large Growth	12/31/1999	1.23	112.0	-46.74
Fidelity Advisor 130/30 Large Cap	US OE Large Blend	3/31/2008	1.55	288.0	-44.75
Fidelity Advisor Mega Cap Stock (FGTAX)	US OE Large Blend	2/5/2008	1.01	97.0	-40.18
BNY Mellon U.S. Core Equity 13/30	US OE Large Blend	8/1/2007	2.71	164.0	-43.36
BNY Mellon Large Cap Stock	US OE Large Blend	7/11/2001	1.05	56.0	-44.36
MainStay 130/30 Growth	US OE Large Growth	6/29/2007	1.50	311.0	-40.80
MainStay Large Cap Growth (MLAAX)	US OE Large Growth	6/30/1995	1.23	115.0	-32.98
MainStay 130/30 High Yield	US OE High Yield Bond	12/14/2007	1.29	26.0	-11.72
MainStay High Yield Corp Bond (MHCAX)	US OE High Yield Bond	1/3/1995	1.07	29.0	-20.13
MainStay 130/30 International (MYITX)	US OE For Large Blend	9/28/2007	1.69	204.0	-56.32
MainStay International Equity	US OE For Large Blend	1/3/1995	1.46	82.0	-37.32
Nicholas-Applegate Global Eq 130/30	US OE World Stock	4/1/2008	--	--	-44.93
Nicholas-Applegate Global Select	US OE World Stock	9/30/1997	1.03	80.0	-43.86
RiverSource 120/20 Contrarian Equity	US OE Large Blend	10/18/2007	1.50	23.0	-49.44
RiverSource Large Cap Equity	US OE Large Blend	3/28/2002	0.97	68.0	-52.65
RidgeWorth US Equity 130/30	US OE Large Blend	12/27/2007	1.30	87.0	-42.78
RidgeWorth Large Cap Core Equity	US OE Large Blend	5/7/1993	1.11	78.0	-43.50
Data as of 3-31-2009.

No Free Lunch
130/30 funds, unlike traditional mutual funds, have an additional hurdle called negative carry, which refers to the cost of shorting and leverage. If the fund manager produces gains through shorting (and this is a big if), he or she must earn extra returns, above and beyond the cost of the carry.

Negative carry is the difference between the financing costs (the prime broker's lending rate) and the interest received on the short-sale proceeds held as collateral. The short-sale proceeds of a 130/30 fund in most cases are not used to purchase more stocks. Rather, they are required to be held as collateral at the prime broker, earning interest. Prime brokers charge a "haircut," which is netted against the interest paid on short-sale collateral, to compensate for locating and controlling the stock they lend to customers. And the haircut grows for "hard to borrow" or illiquid stocks. Finally, after shorting 30% of the portfolio, funds must buy stocks on margin to arrive at the 130% long position, and these margin rates typically exceed the net interest earned on the short collateral.

In addition to negative carry, shorting stock incurs significant trading costs that buying does not. First, managers pay, rather than receive, any dividends on the stocks they short. This cost increase investors' expense ratios. For example, BNY Mellon U.S. Core Equity 130/30  sports a 2.71% net expense ratio. Per its Aug. 31, 2008, annual report, 38% of its total expenses came from interest, and 15% came from paying dividends on shorts. Second, managers must post additional collateral, or margin, when shorted stocks increase or leveraged long stocks decline in value. Finally, because short-stock positions can lead to unlimited losses (a stock price has no upper bound), these positions are typically held short-term, leading to higher commission expenses from portfolio turnover and short-term capital gains (or losses). Fidelity Advisor 130/30 Large Cap  has a 288% turnover ratio, almost three times that of Fidelity Advisor Mega Cap Stock (FGTAX), a similar large-cap long-only fund.

As you can see, the 130/30 strategy is far from free. Let's now talk about risks.

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