Thursday, January 10, 2008

Will 130-30 Funds take flight?

The interest in 130-30 fund concept continues to grow. Many mutual fund families have added 130-30 funds to their portfolio over the past year.

The “130-30” funds allow managers to short-sell up to 30% of their portfolios, and use the proceeds to buy an extra 30% long. The funds both use leverage and short, attributes which are usually embraced in hedge fund products rather than mutual fund offerings.

Conceptually the fund manager would go long strong stocks while shorting weaker stocks. The expectation is the mutual fund would outperform the market and generate excess alpha for investors. Other possible strategies include merger and instrument arbitrage. One of the concerns raised is how would the industry benchmark the performance of this type of fund.

A recent paper, by Andrew Lo of the Massachusetts Institute of Technology and Pankaj Patel of Credit Suisse, puts forward a proposed 130-30 index. The index uses a number of fundamental and momentum factors to access stocks. Those with the best scores are included in the index as longs and those with the weakest scores as shorts. The research defines a “dynamic bench-mark consisting of a plain-vanilla" 130/30 strategy”.

Note the HingeFire stock screener is excellent tool for identifying stocks utilizing the fundamental and technical criteria used in the type of model outlined in this paper. The model uses fundamental criteria such as P/E, P/S, and P/B as well as technical criteria such as Money Flow, MACD, and RSI. The HingeFire stock screener is one of the few products that offers a full complement of fundamental and technical indicators.

Naturally there are questions whether the type of mechanical approach proposed in the “130/30: The New Long-Only” paper actually represents a valuable index, or is simply another stock picking strategy. This leads to immediate questions about the value of comparing the returns of any particular 130-30 mutual fund against this index. There is an expectation that the market will either accept or reject the dynamic index model over time as the new 130-30 funds become more popular.