Fools Gold - Risk of Shorting Stocks 130/30

By: Paul_Petillo

Risk is an interesting topic for investors. The balance between too much and the right amount are often fraught with problems, not the least of which is cost. But what happens when you openly embrace risk, stepping outside of the norm for the goal of increasing returns?

Pension plans have often found their ability to increase returns for their funds locked behind the rules of buying long. Buying long simply represents the purest marriage of research and instinct. Success was measured against traditional benchmarks such as the S&P 500 and it was against those indexes that fees for running funds were generally compared.

Given the opportunity to increase those benchmark returns by adding a little volatility can almost be too tempting for those who feel trapped in a mutual fund world. Eyeballing managers of hedge funds with more than noticeable envy, these plan managers have decided to whet their appetite for risk and with luck, increase their overall returns with short selling.

The advent of the 130/30 has created just such an opportunity. It has blurred the lines between smart investing and risky behavior. The way this works is simple. A fund takes a short position on a 30% portion of its portfolio, essentially borrowing a portion of their assets against long holdings usually held in an index fund. 

Hedge funds have been using the strategy for years often with mixed results. But their investors come from a different mindset.

Even those funds that were successful at shorting stocks did so for one reason: they were able to charge fees to cover the increased expense of borrowing stocks. Mutual funds do not have the same abilities. 

Fee transparency has always been an issue with investors outside of hedge funds. Hedge fund managers, it has been well noted already charge exorbitant fees for their management. They are notorious for the 20/2, which nets them a paycheck of 20% of the funds under management plus 2% of the profit with no correlation on performance.

Mutual funds live under different fee structures. Which should concern the average investor and the person counting on their pensions. The adoption of a 130/30 strategy by these generally staid plans will raise more than a few money separation issues. 

Investors of all kinds – in pensions, in mutual funds and individually will need to worry about three things. First and foremost are the fees. They will come from the cost of borrowing for the short position while leveraging their long positions. 

No one can pinpoint exactly what those fees are right now. Because there may be an eventual shortage of stocks to short, the fees to borrow them from brokerages could rise considerably as more funds jump into the fray. Those fees, while still undetermined could add 2% to the cost the fund charges.

The second is the open door temptation. Allowing only a specific amount of the fund to be shorted ties the manager to too restrictive a strategy. In the world of hedge funds, no such boundaries exist. If the fund wishes to go all cash, it can do so. If it sees an opportunity to short a greater amount of the fund, leveraging a larger amount of their long holdings creating a 20/180, it could do so without investor approval. Expect fund managers to push for increased opportunities once the door is open.

And lastly, shorting is not for the unskilled. While many managers who have had notable successes in the long markets will be willing to flex their investing skills, keep in mind that many more have tried and failed than have succeeded.

Right now global investments in these funds is rather limited. But that could change rapidly with predictions that the market for this product could climb to over $1 trillion by 2010. Over 80 managers are currently looking to rollout such investment strategies, with the hope that pension managers, their primary customer will be able to “sell” the idea to their hedge fund adverse trustees.

For those of us on the outside of this product, you can expect increased volatility in the small-cap space. Because fund managers bemoan the exodus from their large-cap holdings as the reason to breakout of the traditional long-only mold, the large cap market could see a slow down as well.

By Paul Petillo
Managing Editor
http://bluecollardollar.com

Paul Petillo is the Managing Editor of the http://bluecollardollar.com and the author of several books on personal finance including "Building Wealth in a Paycheck-to-Paycheck World" (McGraw-Hill 2004) and "Investing for the Utterly Confused (McGraw-Hill 2007). He can be reached for comment via: editor@bluecollardollar.com

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