130/30 Funds Structures
130/30 funds are viewed as a way for investors to take advantage of an active manager’s stock picking expertise known as enhanced strategies. But should investors invest in 130/30 funds and what are the risks of investing in such enhanced- strategies.
In order to understand the concept of a 130/30 strategy, it is essential to compare against a traditional equity mutual fund. In a traditional mutual fund, the manager takes a long position (buy) in the stock(s) that he believes will outperform the index. Conversely, having owned the above stock(s), the manager may decide to sell if it transpires that the stocks are not good investments. Thus in the first example the manager purchases the stock to make a positive return whist in the later the manager sells the stock(s) in this portfolio to avoid a negative return.
The second instance highlights the difference for a manager following a 130/30 strategy. Both managers have the ability to take long positions, however only the 130/30 manager has the ability to sell stocks they do not already own in order to take advantage of an underperforming stock. Thus the 130/30 manager can make money by either going long or short positions in the portfolio.
In a 130/30 structure, the manager will be long (buy) stocks worth 130% of the new asset value of the fund as well as being short (selling) stocks worth 30% of the new asset value.
Illustration of a 130/30 Fund
1. A fund with £10m worth of assets (net asset value) and buys £10m worth of stocks (100% long).
2. The manager believes some stocks are over valued and due to fall so borrows £3m worth of stocks and sells those stocks (30% short
3. With the proceeds from (2) above, the managers buys an additional £3m worth of stocks (30% long).
4. The fund thus has £13m worth of stocks long (130%) whilst shorting £3m (30% short)
5. The fund thus has a gross exposure of 160% of Net Asset Value.
NB: the above excludes transaction and borrowing costs.
Fig 1: 130/30 structures
Gross Exposure
In Figure 1, the traditional long only fund has a gross expose of 100% of net asset value by virtue of the absence of leverage. In contrast, the 130/30 fund has a gross exposure of 160% (130+30) of NAV by virtue of the re-investment of the proceeds of the 30% short sale.
Both funds have a net exposure of 100% of NAV however, the 130/30 fund carries higher risk. As we can see the net exposure is always equal to the long only position in all cases however, the enhanced strategy will carry a higher risk than a long only fund.
Returns and Benchmark
By using his stock selection expertise, the long only manager would expect the long only fund to outperform the index but in reality, this may not always possible, after transaction costs and fees. The 130/30 fund by contract will exhibit a different return profile to the long only fund given its enhanced leverage notwithstanding that fact that both portfolios have the same beta-one net exposure to the market. During a bull market returns may be enhanced but there may be greater losses during a bear market. For this reason, the benchmark for a 130/30 fund will not be the market index or the corresponding long-short strategy index but will be a hybrid or proprietary index.
