More mutual funds play both sides of the market

130/30 funds try to profit from winners and losers alike.

Scott Wallace - staff

If you've been itching to play the market like the big pros, but lack their megabuck accounts, more mutual-fund providers have something that might catch your eye: 130/30 funds.

To New York financial planner Karen Altfest, they're a type of "hedge fund in a mutual-fund wrapper."

These offerings, which use a form of long-short investing, have left some observers debating whether they make good investments in today's topsy-turvy market.

Fund-tracker Morningstar Inc. counted 20 such funds as of April 4, but more are being rolled out. This month, for example, Fidelity Investments launched its version, a 130/30 Large Cap Fund, and Nicholas-Applegate Capital Management undraped its 130/30 global equity offering. American Century Funds plans to unveil two 130/30 equity funds this year, a spokesman says.

As for their strategy, these funds take long and short positions at the same time. Long positions are stock holdings that investors expect to rise in price; conversely, short positions are bets that the price of a security will drop.

Here's how a 130/30 fund works: A fund manager invests in a portfolio of stocks, and then takes short positions of up to 30 percent of the value of those invested assets. Proceeds from that short-selling are used to buy more stock for the fund, bringing the "long" portion of the fund to 130 percent of the initial invested capital. As these extra-long positions offset the shorts, it creates a portfolio that is net 100 percent invested.

The process presents a "triple bet," says financial planner Steven Kaye. He illustrates the point this way: Say you gave a 130/30 fund manager $10,000. You're actually betting that he will fare well with $13,000 of stock holdings and $3,000 of short positions. So, with that $10,000 investment, "the manager is really handling $16,000 of positions for you," says Mr. Kaye, president of American Economic Planning Group in Watchung, N.J.

Since this structure creates what some call "an exaggerated account," its outcomes can also be magnified – for better or worse. While on the bright side, it could be a home run for the manager who picks the right stocks both to buy and sell short, it could also be a wipeout if he doesn't. As Kaye explains, "If the $13,000 of stocks don't go up, but the $3,000 of shorted stocks do rise, the result will be crushing on the fund."

Short sales not for the faint-hearted

To be sure, short-selling is risky. To do this, an investor borrows stock from a broker, sells it, and then buys it back later – hopefully at a lower price – and gives the security back to the broker. But if the price of the shorted stock rises instead of falls, losses mount until the position is covered. With shorting, experts say, the loss potential is unlimited.

That's not the only concern with 130/30 funds. Other considerations include fund fees that often exceed those of traditional stock funds, and above-average portfolio-turnover ratios. In the latter case, hefty turnover could produce higher income taxes for investors if the portfolio is held in a taxable account.

Clearly, such funds won't suit every investor. Overall, "people need to think very carefully" about getting into them, says financial adviser Karen Altfest of L.J. Altfest & Co. She wouldn't recommend 130/30 funds to conservative investors and those who need every penny to get them through retirement.

Those who buy these funds should "use them in the portion of their asset allocation they would assign to riskier investments," she says.

At least on the mutual-fund side, performance has been a problem lately for many (although not all) 130/30 funds. Consider the average returns of the 20 such equity funds in Morningstar's database. This year, through April 16, that universe of 130/30 funds averaged a negative 7.5 percent total return, versus the lesser 6.5 percent drop of the S&P 500 stock index.

For calendar year 2007, Morningstar had data on seven 130/30 funds, showing returns that ranged from a 14 percent gain to a 7.7 percent decline.

So far, "we're not seeing any compelling reason why investors need these funds," holds Marta Norton, a mutual-fund analyst at Morningstar. On average, the funds "aren't living up to their promises."

"Because they [can both] short stocks and can have an extra-long exposure," their performance "should edge past that of funds that can go only long," she says. "But it hasn't quite worked that way."

Fidelity spokesman Alexi Maravel says that the firm's new 130/30 fund is "designed to capture better risk-adjusted returns in all market environments."

Yet financial planner Louis Stanasolovich wouldn't recommend "jumping on the 130/30 bandwagon now."

"I do think they make sense for investors," he says. "But in this part of the market, which is a cyclical bear market correction, if not a bear market, I don't think they make sense right now. However, in rising markets, they could capitalize on the leveraging on the long side of the portfolio…. In effect, you own more stocks than the normal portfolio would," he explains.

Thus, when the market climbs, "theoretically, they should get higher-than-index returns," holds Mr. Stanasolovich, president and CEO of Legend Financial Advisors in Pittsburgh.

A few beat the market

But evidently even rough-and tumble markets are manageable for some 130/30 fund purveyors.

One case in point was last year's showing by Nicholas-Applegate Capital Management in San Diego. In the beginning of January 2007, the company launched a 130/30 global equity strategy as a separate account for institutional investors. For 2007, its composite return was a 40.7 percent gain – before fees – versus the 12.2 percent rise of the MSCI All Countries World Index, reports Nicholas-Applegate spokeswoman Susan Hunter.

Partly as a result of that high-charged showing, Nicholas-Applegate unveiled a 130/30 global equity mutual fund (minimum investment: $250,000) on April 1, Hunter says. It will using the same management team and techniques that scored so well last year, she says.

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