Long/short funds - help of hype?

The introduction of the Fidelity 130/30 Large Cap fund in April brought the spotlight back to 130/30 funds; specifically, about whether their performance delivered on the hype. Articles reporting on Fidelity's arrival contribution to the 130/30 space characterized these funds as marketing gimmicks. But are they?

The 130/30 structure has, in fact, been used by institutional investors since about 2002 as a way to increase their equity exposure over the long term by leveraging and spreading the portfolio across more issues, usually 100 or more. The name comes from the percentage of long and short positions. The portfolio is long 130 percent because it goes short 30 percent and uses the cash from the borrowed positions to buy more long positions.

Fund companies borrowed the "hedge" structure to create a product for retail investors. The funds attracted comparisons to hedge funds, which use a similar long-short strategy. A key difference lies in the transparency of the structure. Hedge funds are black-box oriented, with no stated structure. Because 130/30 funds are mutual funds, they are subject to the same requirements for structure and disclosure as other mutual fund products.

Like any mutual fund manager, those using a 130/30 structure must select the securities for the portfolio -- which means rejecting others. In a fund that uses only long equity positions, the manager selects those stocks that he anticipates will increase in value. By using a structure that incorporates short selling, the manager is also choosing stocks that he expects to decline in value. When the manager is right on either count -- winners and losers -- the value of the portfolio increases.

Think of it this way: the manager already has the task of weeding out the losers to create the long portion of the portfolio. Short selling creates the potential to benefit from his analysis of the losers. It also broadens the number of stocks in the portfolio, creating greater diversity.

The increased exposure to equities does increase the potential volatility of the portfolio. For that reason, the portfolio manager must have a truly long-term time horizon. This is why 130/30 funds are more than just a fad -- most of them simply have not been in existence long enough for the strategy to play out to its full potential. That lack of history does not invalidate the strategy, and as some of these funds hit their third anniversary, they may find themselves at the top of the best funds lists.

In selecting a 130/30 fund, advisors need to be comfortable with the manager's long-only strategy, the method for selecting stocks for the long and short positions, the quality of research on which those selections are based and how long the securities are held. These are the same considerations for selecting a long-only mutual fund, but they become even more important because they also provide the basis for the manager's selection of the short positions. Advisors should also look at the way the fund manages risks, especially those risks specific to short sales -- margin calls, liquidity issues and redemptions at the fund level. Because there is no limit to how high a stock's price can go, there is theoretically no limit to the amount of money that can be lost on a short sale. In the event many investors attempt to cover short positions simultaneously, share prices can rise rapidly.

One criticism of 130/30 funds has been that the turnover and expenses the strategy creates, including trading commissions and short-term gains, eat up any extra returns it might generate. Like other types of funds, those expenses will vary from fund to fund, and assessing those expenses should be part of the advisor's due diligence process. Advisors should weigh the expense question against the 130/30 fund's increased equity exposure through leveraging, a strategy that most individual investors do not have the sophistication to employ. In these funds, the fund company -- not the investor -- assumes the margin risk.

Because the 130/30 strategy does have a higher level of sophistication, advisors must determine client suitability for this product. Clients should have a time horizon of at least 20 years for the portion of their assets that they put into 130/30 funds. For clients with less than 20 years, 130/30 funds can be weighted accordingly in their portfolio, for example, a third of their equity exposure in value, a third in growth and a third in 130/30 funds. Placing the 130/30 funds in a tax-deferred account can offset a portion of the risk associated with short-term gains in the fund, which are passed to the investor as ordinary income rather than capital gains.

Dismissing 130/30 funds as a fad ignores the benefits of increased equity exposure created by betting on the losers as well as the winners, along with the leverage that comes with a short sell strategy. The 130/30 structure has served institutional investors well, and given the necessary length of time the structure requires, these funds could have a place in the portfolios of long-term retail investors.

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