More investment managers are starting long-short funds with hedge fund-like properties, showing that financial services firms have not given up on developing new products in spite of difficult market conditions and criticism from some quarters.
New York's Morgan Stanley Investment Management; Boston's State Street Global Advisors, a unit of State Street Corp.; and Baltimore's Legg Mason each started 130/30 mutual funds last year. These portfolios are designed to make both bullish and bearish bets on the market, with a bit of leverage mixed in.
In a typical example, a manager with a portfolio of $1 million could get another $300,000, or 30% of the original portfolio, by using short sales. This gives the manager the chance to go long with the equivalent of 130% of the portfolio's value.
Strategies like 130/30 mutual funds have existed for years, but companies sold them to institutional investors such as pension funds.
Last year, investment firms began offering them as mutual funds targeted to individual investors, 401(k) retirement plans, or other defined contribution programs. Then the hedge fund crisis hit in the summer, making many people wonder whether it was wise to sell new products that make leveraged bets.
"When the market struggled last July and August, there was a lull in fund launches and the 130/30 space, but there are a few more coming out now," said Marta Norton, an analyst at Morningstar Inc. "It's not exactly inundated, but they're testing the waters."
The 130/30 portfolios tracked by Morningstar collectively held $3.98 billion of net assets in December, compared with only $2.03 billion in January 2007 — and the total is likely to keep growing, but performance has been negative.
As of Jan. 25 the average 130/30 fund had shed 12.95% in total return during the preceding six months, according to Morningstar, compared to the S&P 500 index's 11.48% loss.
"There's a limited number that have demonstrated an ability to sell short successfully," said Burton Greenwald, a mutual fund consultant at BJ Greenwald Associates in Philadelphia. "As these funds become increasingly oriented toward retail investors, you're going to get a dearth of capable managers."
Fidelity Investments, the Boston mutual fund giant, is working on developing the Fidelity 130/30 Large Cap Fund that it expects to launch in March. The MainStay 130/30 High Yield Fund, subadvised by the New York Life Investment Management affiliate MacKay Shields LLC, was started in December, and the BlackRock Large Cap Core Plus Fund followed suit the same month.
Why is all of this activity occurring now?
"We're not trying to time the market," said Warren Chiang, a managing director in San Francisco at the Mellon Capital Management Corp. unit of Bank of New York Mellon Corp. He explained that hedge funds first used these types of risk management tools and then the strategy moved into institutional asset management. Now the retail market is beginning to follow suit, he said
Some 130/30 fund managers had already gained experience with hedge fund-like accounts for their institutional investors.
State Street Global Advisors introduced its first 130/30 strategy in 2004, and its investment team has managed a Long/Short Market Neutral Strategy since 1990 that consists of half optimistic and half pessimistic bets.
The team that runs Bank of New York Mellon's Dreyfus Premier 130/30 Growth Fund, which was started late last year, had managed strategies in long-short, market-neutral funds that have existed for many years.
Hedge fund strategies tend to require more active management than regular mutual funds; 130/30 funds' higher portfolio turnover can translate into more sales commissions and work for the investment firms. The average 130/30 fund has an expense ratio of 1.44%, according to Morningstar, compared to the 1.25% charged by the typical front-load, large-cap mutual fund.
Some think that in coming years, the 130/30 funds' ability to make pessimistic bets will wind up offsetting their higher fees. "The short positions we had in our [institutional] portfolio were often the ones adding value in these volatile times," said Brian Shannahan, the managing director of the U.S. active quantitative equity team at State Street Global Advisors.
Even during the tough times for hedge funds last summer, Mr. Shannahan's investments wound up evening out in value afterward as though nothing had happened. And he said that the short positions his team took in home building and discretionary consumer stocks "paid off handsomely" in recent months. "We think that going forward we'll see more opportunities and exploit them," he said.
Others might be willing to agree with Mr. Shannahan. When Cogent Research surveyed 1,266 financial advisers last October, 27% indicated that they plan to sell 130/30 funds to their individual investor clients by the end of 2009.
Some experienced institutional investors are still in it for the long haul. In April the $42 billion-asset Teachers' Retirement System of the State of Illinois approved a plan to diversify its market exposure risk by investing in 130/30 strategies.
In October the fund put two $500 million investments into 130/30 portfolios run by JPMorgan Asset Management and Analytic Investors Inc., a unit of New York's JPMorgan Chase & Co. The Illinois teachers' retirement system also plans to invest another $700 million or so in a similar fashion in coming months.
"August and September were difficult times for quantitative managers," said Stan Rupnik, the chief investment officer at the Illinois Teachers' Retirement System. "But that was a short period of time, and it does cycle. There was a benefit to diversifying."
Mr. Rupnik added that his calculation of the 130/30 funds' success will be made over multiple years. "I don't want to judge a manager based on a few months," he said.
