Beware Misuse Of Funds That Short

Several firms have rolled out so-called 130/30 funds. Their nickname comes from the fact that, on average, 30% of their assets are borrowed and/or shorted. They reinvest borrowed money in long positions.

Merrill Lynch estimates the total amount in such funds to be $80 billion to $100 billion. But only a small part of that -- on the order of hundreds of millions of dollars -- is in retail funds.

The 130/30 funds are designed to rise with their benchmarks, while falling less in bad times. They are not designed to eliminate any loss.

The only limit on leverage or shorting is whatever a fund's prospectus says.

Leverage and shorting allow funds to boost returns with borrowed money or assets, which effectively increases the amount invested.

Short positions can be paid by gains on the long side if the manager is wrong about them. If bets on short stocks pay off, profits can be moved to the long side.

Managers at firms that offer these funds say that many shareholders assume they offer protection from downturns. That isn't the case.

They can mitigate the market drops, says Scott Bondurant, global head of long-short equity investments at UBS.

"You can expect to do slightly better, and you can expect to be down less than the market," he said.

UBS launched its retail 130-30 fund, UBS Equity Alpha (NASDAQ: - ), in September. It has $230 million in assets. Going into Thursday, it has returned 3.51% so far this year. The S&P 500 returned 3.22% over the same period, and the fund's benchmark, the Russell 1000, returned 3.25%.

UBS' fund is one of the larger ones. Most have only existed a short time.

Extra Points

In a rising market, Bondurant says, one might get an extra two or three percentage points on the return over the S&P 500 or the fund's benchmark.

That's because such funds can put more money to work than they actually have. That's due to borrowing or shorting, which uses borrowed assets.

But in a falling market, all the strategy aims to do is keep the fund from dropping too far below its benchmarks.

Recently many 130/30 funds followed this pattern. They lost ground, but less than their benchmarks.

The Russell 1000 peaked on July 13 at 846.87. Since then it has dropped 6.11%. Equity Alpha peaked on July 17, and has lost 5.55% since then.

Todd Trubey, senior analyst at Morningstar, says too few 130/30 funds have existed long enough to give good categorywide data.

But Morningstar does have data for individual, longer-running funds. They outperformed the S&P by losing less. In the past 30 days, Equity Alpha dropped 0.72%, Mainstay 130/30 Growth Fund (NASDAQ: - ) lost 3.08%, Mainstay 130/30 Core (NASDAQ: - ) lost 0.74% and ING 130/30 Fundamental Research (NASDAQ: - ) dropped 1.4%. The S&P by contrast lost 4.89%.

Since late July there has been an increase in market volatility. A 130/30 fund should cut that. But it isn't designed to earn continuous gains.

Misconceptions about 130/30 funds come from a tendency to compare them to hedge funds, says John Forelli, senior vice president at Independence Financial Advisors.

"I wouldn't use these funds as a hedge for 100% protection against a down market," Forelli added.

These funds offer managers another way to bet on a stock.

In a traditional long-only fund, the only way for a manager to bet against a stock is to have none of it. He can overweight those he likes.

But in a fund where he can short, a manager can profit by betting against a stock he doesn't believe in.

The 130/30 funds also are becoming more popular because of rule changes.

Before 1997, a fund could only make 30% of its gains from short-term holdings. A special, higher tax rate kicked in if more than 30% was short term. A rule change gave funds more flexibility.

A bigger boost came from killing the so-called uptick rule in June. The rule barred investors from shorting a stock that was sliding -- it had to have risen in its most recent trade.

Free Hands

Ric Thomas, senior managing director who heads State Street Global Advisors' unit that runs 130/30 funds for institutions, says in a falling market managers who only invest long have their hands tied.

All such managers can do is hope their long bets fall less than the overall market. But managers who short can score positive returns in a falling market.

He adds that 130/30 funds don't reduce total risk. They are only designed to offset long losses using shorts.

It's one reason State Street initially saw interest from institutional investors, who are more familiar with such strategies.