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.
Paul Petillo
www.BlueCollarDollar.com
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