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130/30 Funds: 130% Gimmick/30% Good Idea -- Page 2

Don't get swept up by these funds.

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Measuring Risks
Some 130/30 fund literature says the risk of a 130/30 fund is equivalent to the benchmark index's or an equivalent long-only fund's. This can be true, but only with much risk management. Many long-only managers do not closely monitor the market risk of their portfolio or underlying stocks, as their mandates allow only relatively small departures from the benchmark in the first place. 130/30 managers, however, must carefully measure this risk to stick to their investment objective.

Market risk and exposure can be estimated by beta (the sensitivity of a stock to a particular benchmark), and the beta of a fund is the weighted average of the betas of its stocks. The beta of the benchmark index is 1.0. In order for market exposure of a 130/30 fund to match that of its index, the collective beta of the 130% long stocks should be 1.3, and the collective beta of short stocks should be 0.3. The problem with beta is that it is largely a historical measure, and we all know past stock returns never perfectly predict future returns. So it's highly possible for a 130/30 fund to have more or less risk than its 100% long counterpart. From a practical standpoint, this risk exposure must be actively monitored and traded, which of course has costs. So 130/30 managers must weigh the cost of hedging against the benefit.

As you can see in the table below, several 130/30 funds do not keep their betas close to 1.0, so investors are not getting 100% market exposure in these funds--sometimes it's more, and sometimes it's less.

Nadia Papagiannis does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.