How much do you love your manager? 130/30 or bust!

The market stinks, your IRA gets smaller every day, what’s a poor investor to do? Aren’t there ways to make money from falling stocks — right — shorting. Sounds risky (and it is). But what if there was a way to have a mutual fund do some stock shorting without much risk? Sounds cool. Cool enough to propel a growing trend in fund introductions. But be careful not to believe the hype about the new wave of “130/30” funds. There’s more risk than meets the eye, lots more.

Fidelity was the latest on the bandwagon this week, launching its 130/30 Large Cap fund on Monday. I don’t mean to pick on Fidelity — its fund has the same issues that plague earlier entries in the 130/30 wave but it will suffice as an example.

In concept, this new class of funds is fairly formulaic. Fidelity’s fund plans to sell short stocks with a value equal to 30% of its assets. In a short sale, the fund borrows shares it doesn’t own and sells them. The fund gets cash from the sale but eventually owes the original shareholders back the shares. It also owes any dividends that the shares pay. If the price of the borrowed shares falls in the meantime, the shorting fund prospers. But if the price rises, the fund loses.

If it stopped there, you might consider that less risky than a typical all-equity fund. So-called market neutral type funds that do this (usually investing the short sale proceeds in Treasury bills) have a pretty good record so far this year. But 130/30 funds go further and use proceeds of the short sales to buy more long stock positions. So for every dollar an investor puts in the fund, the fund owns $1.30 of stocks and shorts another 30 cents worth.

The seemingly perfect symmetry lets 130/30 funds claim they are no more risky than the overall market. And in one sense, that’s true. If the fund simply invested all its long positions in a market index and its short positions in the same index, it would all balance out. The amount that the fund’s price varied from day, its volatility, would be comparable to the overall market. That’s the theory, anyway.

But 130/30 funds are actively managed — the manager is making all the picks, long and short, to beat the index. For every dollar an investor has invested, the fund manager has put $1.60 worth of bets on the line. That’s great if the manager is right but as the record shows, most managers lag the market. Now your manager has more firepower to lag the market by an even bigger gap. Better have a lot of faith in that manager.

Check out the track record of some of the existing 130/30 funds and decide for yourself if the much vaunted shorting capabilities have helped managers navigate this year’s tough market. ING’s 130/30 Fundamental Research Fund (Symbol: IOTAX) is down 9.67% year to date, trailing the S&P 500 by 2.46 percentage points, and comparable to the Dreyfus Premier 130/30 Growth Fund’s 9.62% year to date loss. Blackrock’s Large Cap Core Plus Fund (BALPX) is down 11.61%. The UBS Equity Alpha Fund (BEAXX) is down 8.34% and the Legg Mason Partners 130/30 US Large Cap Equity Fund (LMUAX) is down 8.77%. Mainstay’s 130/30 Growth Fund (MYGAX) is down 8.77% while the firm’s core 130/30 fund (MYCTX) is the only one of the breed I found that’s ahead of the index, down just 6.08%. Those are all the 130/30 funds I could drum up on Morningstar and returns are as of April 9. State Street’s SSGA Core Edge Equity Fund (SSCSX) doesn’t come up on Morningstar, but it’s listed by the firm as having lost 9.44% through the end of March.

There’s also the hairy issues of stock shorting and leverage. Thomas Kirchner, who manages a fund that engages in short selling for the Pennsylvania Avenue Funds, warns that because 130/30 funds want to use short sale proceeds to leverage their portfolios, they’re subject to a lot of extra costs. Brokers require a stock shorter to leave some of the proceeds as a form of collateral and charge a variety of fees. That can be a big drag on performance, making it harder for the funds to beat the index, Kirchner notes.

Maybe you thought the fund industry learned its lesson from all the Internet funds launched in 1999, but no. With the latest hot fund trend, still seems like the best advice is to head for the hills.

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