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The latest industry innovation that advisers will have noticed is the launch of a number of funds styled “130/30”. At their simplest 130/30 funds can be regarded as a half way house between “standard” equity funds and hedge funds. 130/30 funds originated in the US and estimates suggest that approximately US$50-60 billion is currently invested in 130/30 style funds globally and this figure is growing at a significant rate. The popularity of these type of funds is based on their potential to enhance returns by using both long and short positions.
Essentially 130/30 funds combine a traditional portfolio of stocks, known as a “long-only” portfolio, with a 30% long/30% short portfolio, where the proceeds of selling short positions in unfavoured stocks is invested in more long positions.
For example, Merrill Lynch has produced using three nominal stocks, A, B and C to demonstrate various different investment strategies. In this example A is considered a good stock, B mediocre and C overvalued.
Given a choice of these three stocks to invest in then a “best ideas” concentrated long only portfolio would only invest in stock A while a more traditional long only fund may include an element of stock B in order to reduce risk. Alternatively a market neutral or long/short hedge fund could finance a long position in A by short selling C.
Looking at the potential returns generated by these differing investment strategies then in simple terms the long only funds offer mostly beta, or market returns, while the hedge fund is all alpha or stock specific return. It must be remembered, however, that while the hedge fund is potentially offering a better return than the market it could also do far worse than the market if C should outperform A.
Until recently these have been the only options open to UK retail investors but with the advent of 130/30 funds what we are seeing is an attempt to take the best of both worlds and incorporate them into one offering. Thus a 130/30 fund will hold 100% of stock A, then short sell 30% of stock C to finance a further 30% position in stock A.
This means that a 130/30 fund provides market exposure or “beta” but also enables the fund to generate additional alpha, (known as “portable alpha”), because if stock A does as expected and outperforms stock C, the fund will have captured 130% of the upside.
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