Monday, September 1, 2008
New "Product" From the Mutual Fund Industry: Not a Good Idear for You
and here's the WSJ on the same type of funds on Jan 24,2009
Leverage Shakes Up Mutual Funds, Which Discover a Strategy's Downside
By SHEFALI ANAND
In recent years, more mutual funds have used borrowed money to juice returns and lure investors. Now, they are discovering the downside of leverage, and some are cutting back.
Early last year, Wall Street was heavily promoting several new types of funds that rely on borrowing money. These include so-called 130/30 funds that aim to amplify market returns by betting against some stocks,
Two Sides to Leverage
While borrowing money can improve returns in good times, it also widens losses in bad times, and that is what happened in 2008. Some of these funds ended the year with even greater losses than the market as a whole. For instance, of the 15 mutual funds that apply the 130/30 strategy for U.S. stocks, only a third beat the Standard & Poor's 500-stock index in 2008, according to Morningstar Inc. Some of the laggards fell behind the index by five percentage points."
And other mutual funds attempting to mimic hedge funds by using leverage had dismal results. In my view leverage funds have no place in portfolios.
Even some traditional mutual funds that use leverage opportunistically have been hurt. The $1.5 billion Baron Partners Fund, which uses bank borrowing to increase its stock bets, fell 46.7% in 2008, nearly 10 points worse than the S&P 500's total return. Fund manager Ron Baron declined to comment. In a recent shareholder note, Mr. Baron said he believes that the companies his funds' invest in will "recover their value over the next several years."
Of course, leverage has shaken up a lot more than the fund industry. Excess leverage on Wall Street is a big reason for last year's market meltdown. A number of hedge funds, which had borrowed heavily to turn a mound of equity into a mountain of assets, were forced to sell their positions to meet demands from creditors. This depressed various stock, bond and commodity markets.
And it seems that those marketers at the mutual fund companies are having second thoughts on their formerly "hot product":
There's going to be a move toward simplicity after this market downturn," says John Rekenthaler, vice president of research at Morningstar. He thinks the 130/30 funds are going to struggle to grow from here on.
"It's a new type of fund, with fairly aggressive promises, complicated strategy, and they didn't perform well in the bear market," Mr. Rekenthaler says. " ... To me, that all spells investors and advisers saying, 'What's the point?' "
How do 130/30 funds work? For every $100 invested, the fund will borrow stocks valued at $30 to sell "short" and invest this cash raised in the market, thus making the gross investment equal to $130.
Paul Quinsee, who heads the team managing the largest 130/30 mutual fund, JPMorgan U.S. Large Cap Core Plus fund, expects the investing strategy to survive. His fund dropped about two points less than the S&P 500's total return last year, making it among the best performers amid such funds.
Mr. Quinsee says the fund managers cut back on the amount of leverage in the fund, bringing it to less than 120/20. He declined to specify the funds' short positions but said his fund did what it's supposed to do.
Some other 130/30 funds didn't fare as well. Funds that lagged behind the overall market included the Old Mutual Analytic U.S. Long/Short fund, the Dreyfus 130/30 Growth fund, RiverSource 120/20 Contrarian Equity Fund and the UBS U.S. Equity Alpha mutual fund.
Scott Bondurant, co-manager of the UBS mutual fund, said his fund was hurt particularly after September, as panicked investors dumped some of the stocks owned by the fund to gravitate toward stocks of companies perceived to be safe during a recession. Currently, its strategy is down to 125/25.
Managers of the other funds declined to comment.
The biggest users of leverage are closed-end funds, versions of mutual funds that trade like a stock. About 72% of the 600-odd funds use leverage, according to Cecilia Gondor of Thomas Herzfeld Advisors Inc. They borrow money at lower, short-term rates and invest it in securities that they expect will earn them higher returns
Under Pressure
However, this strategy came under pressure early last year, as their main route for borrowing, auction-rate securities, froze up. Since then, the closed-end funds have been paying higher rates on their borrowing.
Later in the year, as net asset values declined, several funds had to deleverage or get rid of borrowing entirely to meet legal requirements. Closed-end funds are required by law to maintain $3 of assets for every $1 borrowed as debt, and $2 for every $1 issued as preferred shares.
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