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

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.

S&P 500 Beta Comparison
	Category	Weekly Beta 3/23/08-3/21/09 USD
BNY Mellon U.S. Core Equity 130/30	US OE Large Blend	1.01
CRM 130/30 Value	US OE Large Value	0.87
Dreyfus 130/30 Growth	US OE Large Growth	0.96
ING 130/30 Fundamental Research	US OE Large Blend	0.95
Legg Mason Partners 130/30 US Lg Cap Eq	US OE Large Blend	0.88
MainStay 130/30 Core	US OE Large Blend	0.99
MainStay 130/30 Growth	US OE Large Growth	0.90
RidgeWorth US Equity 130/30	US OE Large Blend	0.95
RiverSource 120/20 Contrarian Equity	US OE Large Blend	1.13
Robeco WPG 130/30 Large Cap Core	US OE Large Blend	1.01
Wilshire Large Cap Core 130/30 (WLCTX)	US OE Large Blend	0.90
Data as of 3-31-2009.

Shorting: Not the Opposite of Going Long
Many 130/30 funds were launched by long-only fund companies and managers with no shorting experience. To compensate for lack of skills in shorting, these fund companies require managers to stick to a specific long/short structure (even though the SEC allows any exposure, static or dynamic, up to 150/50) and to use purely quantitative stock-picking models, simply ranking a universe of stocks from best to worst according to factors designed to find good buys, or good long stocks. Then, the bottom-ranked stocks are selected as shorts. However, just because a stock isn't a good buy, doesn't mean it's a good short. Unlike buying, shorting a stock requires a detailed assessment of risk, availability, and timing.

Losing short positions (when the stock goes up) become greater allocations in the portfolio while winning shorts (stock goes down) become smaller allocations. On the long side, the winners become larger and the losers become smaller--a natural hedge. So the manager has to have many more winners on the short side than on the long side, and the portfolio has to be constantly rebalanced. Small positions, stop losses or a strict sell discipline (covering a short if a position declines a certain percent), can help mitigate downside risk.

Another thing to consider is liquidity. Small-cap stocks are less available and more expensive to short. And there are trading issues. Shorting is often driven by short-term sentiment and momentum or price factors rather than long term-fundamental issues, and it takes an experienced trader to appropriately time the trade.

There's Still Hope
While we believe that 130/30 or 120/20 funds are largely marketing gimmicks, the idea of a long portfolio, combined with a short extension to emphasize a manager's best and worst picks, is a good one. But the key to success is a dynamic short-extension, rather than sticking to a static 130/30 or 120/20 model, which has no economic rationale.

Take  JP Morgan U.S. Large Cap Core Plus (JLCAX), which is virtually identical to its U.S. Equity Fund (JUEAX), differing only in the short-extension, which tactically varies, and currently hovers around 118/18. Notice a gimmicky descriptor is absent from the fund's name, and it is also absent from the fund's investment mandate. The fund's manager, Tom Luddy, can position the portfolio as he wants based on current market opportunities, as long as the portfolio keeps a 100% net long market exposure.

This fund differs from many 130/30 funds in that its stock-selection process is fundamental and bottom-up, rather than quantitative. This allows Luddy and his analyst team to take advantage of strong convictions on which stocks to long and short, the purpose of a 130/30 fund. Luddy is heavy on risk management, and it shows. The 52-week beta (to the S&P 500 index) of the short extension fund almost exactly matches its long-only equivalent, which ranges between .97 and 1.04 on a rolling six-month basis. The fund's maximum drawdown, the largest loss experienced by the fund, occurred between October 2007 and February 2008, and differs from that of its long-only brother by only 30 basis points. Meanwhile, its performance since inception (from Nov. 1, 2005 through April 16, 2009) is significantly better, by 8 percentage points. Same risk with better returns--what typical 130/30 funds promise, but can't deliver.

The lesson is that short extension funds make sense when run with the correct expertise, but gimmicky mandates don't.

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