Friday, September 3, 2010

One of Wall Street's Worst Creations

Yesterday, The Wall Street Journal highlighted "130/30 mutual funds" that were popular leading up to the financial crisis in mid-2007 but have since fallen out of favor with investors, given their high amounts of leverage and lackluster track record.

I remember hearing about these funds back in 2007 and thought they defeated the purpose of what mutual fund investing should be: a low-turnover, disciplined implementation of an investment policy predicated on achieving long-term returns. Instead, 130/30 funds aim to invest $100 by going "long" in stocks, hoping they will rise, and shorting - betting against - $30 worth of stocks using borrowed shares. It gets much worse, though! The funds then take the proceeds from their $30 of shorts and go long $30 more worth of shares to make a total of $160 in bets on various stocks in two vastly different forms. You don't need me to tell you why that much leverage can seriously hurt you should the market turn sour.

Worse still, these expensive funds have had terrible risk-adjusted returns and investors are fooling themselves if they think that these funds offer anything more than a clever marketing ploy. For example, the MainStay 130/30 Core C (MYCCX) is just one of the options investors have should they choose to add the 130/30 model to their portfolio. It won't be fun trying to recoup the high expenses and 1% load, though. In light of these fees, this fund would need to earn 3.35% per year just to break even!

If the active portfolio managers of your typical mutual fund fail so often at beating a benchmark index, what makes people think that a juiced-up and riskier version of this costly model will succeed? It doesn't and it won't. The Journal says that,
"From March 6, 2009, through Aug. 13 of this year, when the S&P rose 47%, the seven funds that weren't liquidated or merged out of existence gained an average of 41.2%, compared with 43.4% for their long-only siblings." That begs the question: What exactly are investors paying for?

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