130/30 Funds

Answer 1

In my last couple posts I talked a little about the difference between long and short investing. Remember that short selling is the strategy you employ when you believe a stock is going to go down in value. You simultaneously borrow the shares and sell them from your broker, with a promise to buy them at a future time and return them. The hope is that the share price will be lower in the future when you have to return the shares.

Now I want to discuss 130/30 funds. (You may also see 120/20 funds or 150/50 funds – same concept. For my explanations I’ll be using the 130/30 construction.) These are mutual funds that invest 100% of the cash they receive in a long portfolio. They then sell short assets that they believe to be overpriced by the market, up to 30% of the original long portfolio. With the cash they receive from the short sales they turn around and invest an additional 30% in the long portfolio. In essence, the fund has used leverage to multiply the effect of their investment decisions. The result is a long portfolio that is 130% of the original invested capital and a short portfolio that is 30% of the original investment.

This structure does a good job of magnifying gains when the investment manager has made a good call. However, it also will magnify any losses on bad calls by the manager as well. Remember, when you engage in short selling your risk of loss, at least in theory, is infinite. The fact that you’ve hired an investment manager to make the decisions instead of you doing it doesn’t protect you from this risk. And also, when you do short selling short interest must be paid. This, along with the fee you pay to the investment manager will erode your gains, if you had any gains.

This kind of leveraged structure used to only be available to those qualified to invest in hedge funds. However, recently they’ve been making appearances in mutual funds. Please do your research before engaging in these types of funds. The risk is much higher than with traditional long-only mutual funds.