Fidelity follows dubious fad by opening 130/30 fund

Date: Monday, April 21, 2008
Author: Chuck Jaffe, Boston Herald.com

Mutual fund companies come up with new ideas all the time, but most don’t gain any traction.

So when Fidelity Investments joined the latest trend earlier this month and opened a 130/30 fund, it signaled that the newest fad in funds had gone big time.

The question is whether this new flavor of funds has any role in the average investor’s portfolio, because the new genre of funds comes complete with hype about how a hedge-fund-like option can provide added diversification and protection against a down market.

In truth, the new funds sound more appealing than they are likely to be for most investors, and early returns don’t seem to justify the hype.

There are about two dozen funds - the latest being Fidelity 130/30 Large Cap (ticker: FOTTX) - available now that loosely fall into the new genre of funds. They have been described in any number of ways - including limited-shorting funds, enhanced-alpha funds, hedge fund lite and more - but the 130/30 moniker is the one that seems to be sticking. The numbers are a description of what these funds do.

While the percentages can vary, a 130/30 fund invests 130 percent of its assets in long positions - stocks where the manager is betting the price is going up - and 30 percent in short positions, where the expectation is that the price will go down. In a short sale, the seller borrows stock and sells it on the open market, getting the cash from the sale; if the stocks share price falls, the investor buys back the shares at a lower price, returns them and pockets the difference.

The proceeds from those short sales create the extra 30 percent of long exposure. On a net basis, the extra long and the short position cancel out and the fund can claim to simply be fully invested. For the average investor, however, the effect feels similar to a fund that uses leverage; the extra investment is there, theoretically, to turbocharge returns.

The idea is pretty simple: In a traditional fund, the manager can only put money on stocks that appear headed for take-off; in a 130/30 fund, the manager gets to put all of their information to work, betting on crash landings too, a hedge that is particularly attractive in times like these, when the market is struggling to get any traction.

If it sounds vaguely familiar, that’s because it’s a twist on long-short funds and market-neutral funds, both of which brought certain qualities of hedge funds - notably a purported ability to make money in all market conditions - to ordinary mutual funds. Alas, the vast majority of those fund types have failed to deliver on their potential; most market-neutral funds have been extremely neutral about the market, unable to make decent money in all market conditions.

Clearly, performance is an issue, as the realistic expectation for a stock that can make bets in all directions would be that it can deliver superior performance in all market conditions. An analysis by Investment Week magazine recently noted that 130/30 funds are largely failing to outperform their long-only peers since they started coming to market last year. That’s a short time frame for the funds, but if they can’t deliver in challenging market conditions, investors should wonder if there’s a reason for these funds to exist. At the very least, investors should question whether these funds are worth taking a flyer.

“There’s no proof, as of now, that a 130/30 fund will do better than an ordinary large-cap fund, and I think most investors would be better served by having a plain vanilla growth fund, rather than something that is this complicated and which they don’t understand well,” says Gregg Brewer, executive director of research for Value Line. “These are funds that give the marketing department something new to sell, but I’m not sure they give an average investor something new to buy.”

Standard & Poor’s recently issued a research paper suggesting that the performance of 130/30 funds should be measured against traditional, long-only benchmarks like the S&P 500. The firm maintains that leveraged long and short positions are just another form of active bet against the market, and that the goal of the funds is to beat the market while controlling risk.

The flip side of this is that 130/30 funds - and all mutual funds pursuing hedge-fund strategies - tend to have high turnover and above-average costs, which make it that much harder to beat the index.

“There will be some good funds in this area, but it’s too early to know which ones, or if they’re even the ones that are open now,” says Russel Kinnel, director of mutual fund research at Morningstar. “We saw with market-neutral funds and long-short funds that hedge-fund strategies don’t always work well in mutual funds. . . . We’ll probably see the same kind of mixed results with 130/30 funds, so investors shouldn’t rush in right now when they can wait for proof that the strategy works.”