New "Product" From the Mutual Fund Industry: Not a Good Idear for You

The actively managed mutual fund industry seems never to tire of new “product” which seems to be aimed at distracting investors from their long term interests by pushing them to make investing decisions based on short term developments. One of the latest” innovations” is the 130/30 fund which purports to offer investors positive returns regardless of movements in the overall stock market and…at lower risk. Not surprisingly the combination of extensive marketing and investors willingness to jump from one faddish investment vehicle to the other has led to large scale inflows into this strategy. Investment News, an industry newsletter recently reported on this development:. Article text in italics My bolds, (my comments in parentheses.)


Appeal of 130/30 funds swells
Advisers warned to be cautious in selecting these investments
By Jeff Benjamin
August 25, 2008
The wild popularity of 130/30 funds notwithstanding, recent analysis of the unique long-short strategy suggests that advisers would be wise to check under the hood for a closer look at the portfolio and not just jump in to the latest marketing craze.
"Some of these strategies are taking on a lot of risk for the returns they're generating," said Steve Deutsch, director of separate and collective trusts at Morningstar Inc. of Chicago.
According to Mr. Deutsch, a growing appetite for alternatives to plain-vanilla long-only investment strategies has fueled a stampede into the space by the financial services industry. A recent forecast has projected that assets in the strategy, also known as short-extension and leveraged-net-long, will swell from around $100 billion today to $2 trillion by 2010, according to research from the Tabb Group LLC of New York.
There are already 90 money management firms offering more than 200 products …... .
For financial advisers and their clients, the challenge will be sifting through the heap of new products that all claim to have mastered the balance of leverage and short selling inside a single portfolio. …
The basic strategy, which has been building momentum for almost five years, is a twist on the long-short hedge fund strategy that has been around for more than 50 years.
The idea behind a short-extension strategy is to short-sell a percentage of a portfolio and apply the same percentage to leverage on the long side, thus maintaining a 100% net long exposure.
Applied to an index such as the Standard & Poor's 500 stock index, the strategy would enable a manager to sell short those stocks he least favored while leveraging long his favorite stocks in the index.
In theory, the strategy, which can be applied to both stock and bond portfolios, is expected to outperform a designated benchmark on a risk-adjusted basis.
(looked at objectively there are several reasons not to expect this strategy to deliver on its promise

• We know from long term data that active fund managers seldom succeed in beating their benchmark index when going long stocks. It seems unlikely that they would be more successful when choosing stocks to go short. In addition many managers of these 130/30 funds have little experience in shorting stocks.
• This strategy is quite likely to add risk and volatility to a portfolio. While a long position’s maximum loss is known (a stock cannot fall below zero) the loss of a short position is potentially infinite (there is not limit on how high a stock price can rise))
As the article notes:

In practice, however, the strategy demonstrates that traditional long-only money managers don't always excel at selling stocks short.
A key element of the strategy is to reduce risk, as measured by beta, in comparison with a designated benchmark.
In analyzing the returns of 40 different 130/30 strategies over the 12-month period through June 30, Mr. Deutsch found a beta range from 3.5 to a negative 1.25. A beta of 1 is considered to be subject to risk equal to that of the benchmark.
(once again in this active strategy as in traditional actively managed funds, one is betting on a “genius” manager, not only will past performance in terms of returns not indicate future performance, the same can be said for the risk measue=beta)
Mr. Deutsch found that 29 strategies were below that mark and 11 were above the benchmark beta.

(and as mentioned there is no guarantee that the funds’ risk characteristics will remain constant over time)
In analyzing the respective portfolios, he found that managers were using a wide range of strategies and in some cases taking on additional risk to increase performance.
"In some cases, investors are probably getting more risk or less return than they bargained for," Mr. Deutsch said, though he added that most investors only focus on return. (the major peril in buying actively managed funds conventional or exotic: you never really know what you own)
.

The fact that some money managers are now migrating toward ratios of 140/40 and even 150/50 doesn't bother Mr. de Silva, who insists that the ratios are irrelevant as long as the beta is held close to 1.TRACKING ERROR, RISK
"The ratio will vary over time, but we say, 'just focus on the tracking error and the risk and don't worry about the ratios,'" he said.
(now there’s an illogical argument, the more you increase the short ratio, the more you differ from the benchmark of the s+p 500 thus the more risk that your tracking error will increase. Of course they “focus on the tracking era” but the larger the short position the harder it is to succeed In fact in the very next paragraph below he acknowledges the additional risk:).
Risk, however, can be amplified, depending on the short-selling expertise of each money manager. "A lot of people starting these strategies don't realize that when you short something and are wrong, that position just gets larger," Mr. del Silva said.

(taking the first paragraph of his statement together with the second one, Mr. De Silva’s argument seems to be “when other people do what I do they are amplifying their risk, but when I do it all the risks are controlled and there is nothing to worry about. In other words I’m a genius, no worries. No thanks0(But interest in the product is growing as investors are attracted to the promise of the perfect investment vehicle: positive performance in down markets at less risk than the overall stock marke Meanwhile, the market continues to move in the direction of 130/30 strategies, with growing supply meeting growing demand.
"

We see a lot of traditional money management firms launching 130/30 strategies and we see these funds grabbing a larger share of the long-only assets already under management," said Adam Sussman, director of research at Tabb Group.
However, Mr. Deutsch is among those who worry that the strategy is becoming an investment fad tied largely to an interesting label.
"We think the 130/30 strategy is just the latest is a long line of products that have grown due primarily to competition," he said.

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