130/30 Funds: 130% Gimmick/30% Good Idea
Don't get swept up by these funds.
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 (MSEAX). Only one 130/30 fund significantly outperformed the long-only fund: Mainstay's 130/30 High Yield (MYGAX) topped High Yield Corporate Bond (MHCAX). Why did so few of these funds live up to expectations?
Nadia Papagiannis does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.