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130/30 Mutual Funds: Don’t Believe the Hype

By: Investor Solutions

By: Robert J. Gordon, MBA, AIF, CFP

Do these times of increased market volatility have you wondering, “How can I protect myself from market downturns?” If so, the wizards of Wall Street claim to have designed a fund to calm your nerves and line their pockets: the 130/30 mutual fund. They are touted as a great way to outperform the market and lower the volatility of your portfolio (sort of like “Taste’s Great, Less Filling”). However, the evidence suggests that the average investor should stay away from these funds and stick with the time-tested success of a well-diversified, global equity portfolio.

What is a 130/30 mutual fund?

The 130/30 is an investment strategy that seeks to deliver market-like returns with reduced risk. Their structure is best explained through an example.

Let’s say you invest $1,000 in one of these funds. Let’s also assume that the fund is focused on large capitalization stocks and uses the S&P 500 as its benchmark. The portfolio manager (“PM”) sorts through the S&P 500 to identify the stocks she expects to be the best performers over some period of time. She will then invest your $1,000 in those stocks. The PM will then sell short up to 30% or $300 of the stocks she expects to be the worst performers in the S&P 500 index. By selling short, she is selling shares she does not actually own with the expectation of buying those shares back at a later time or date and at a lower price. Using the $300 she received from the short sale, she invests in her previously-generated list of future top performers. You now have $1,300 worth of equity exposure for $1,000 of invested capital. The 130 in the fund’s name refers to being 130% long the original investment and the 30 refers to being short 30% of the original investment.

The Odds Are Against You

Over 100 years of research and real world experience suggests that the PM will not, over the long term, succeed in her quest to pick winning long and short trades. Markets work and forecasting stock prices is a wasteful and expensive activity. This is supported by countless academic and industry studies and by the absence of actively-managed mutual funds with long track records of beating their indices. Kenneth R. French, a Director of Dimensional Fund Advisors and a professor of finance at Dartmouth College, maintains:

  • The expected payoff from the typical active manager is negative
  • The probability of identifying a superior active manager is very low
  • The expected payoff from hiring an active manager is almost certainly negative

In fact, Professor French’s research shows that the additional cost of an active mutual fund over a passive mutual fund is almost 1%.1

Leverage Magnifies Risk

Short selling requires leverage and that magnifies the risk in this strategy. Let’s assume that the same PM we referenced earlier is also managing a NASDAQ-based 130/30 fund. At the end of 2007, she identifies Yahoo as a stock she believes will be in the lowest quartile for performance in 2008. Consequently, she shorts Yahoo on January 2, 2008 at $23.00. Remember, her expectation is for the price to drop over the next 12 months. On January 31st of the same year, Microsoft made an unsolicited offer to buy Yahoo for $31.00 per share. That is 60% above the closing price on January 30th. For a short seller, this is a nightmare scenario because they now have an immediate and large loss on this position that can become significantly larger if the price continues to rise. If shares are in short supply, the short seller can be forced to buy back the shares at ever higher prices as margin calls force them to pay whatever it takes to close their positions. The prospectuses for many 130/30 funds acknowledge this risk. The wording typically reads:

“Because the Fund’s loss on short sales arises from increases in the value of the security sold short, such loss is theoretically unlimited. In certain cases, purchasing a security to cover a short position can itself cause the price of the security to rise further, thereby exacerbating the loss.”2

Fund companies are under no obligation to explicitly state the increased risk due to leverage in anything other than general terms and, as a result, it is virtually impossible to properly assess the investment’s risk.

Short Selling Is Expensive

At last count, there were less than 20 of these funds available to the investing public. The majority are load funds and the typical upfront sales charge for A shares is 5.0%+. Published operating expenses are in the 1.4% to 1.7% range but it is important to note that these funds can be far more expensive than their long-only counterparts. As a matter of fact, New York Life’s MainStay 130/30 core fund notes in its prospectus that the parent company has entered into an expense limitation agreement with the Fund. It essentially states that it has agreed to cap the Fund’s management fee and total annual operating expenses at 1.5% for the A shares. However, it excludes the following from the calculation of the total annual operating expense: taxes, interest, litigation, dividends and interest expense on securities sold short, extraordinary expenses, and brokerage and other transaction expenses relating to the purchase or sale of portfolio investments. These are the expenses most likely to skyrocket if the short sales go wrong.

And the performance…

Of the 17 funds listed in the 130/30 category on, only two (2) have been around for more than three (3) years. The Natixis Westpeak 130/30 Growth (symbol NEFCX) is the oldest on the list. It was launched in 1992 and sports a consistent record of underperforming the S&P 500 – sometimes by a large margin. In 2007, it underperformed by almost 10%. $10,000 invested at the beginning of 1998 in this fund is worth $10,000 today. By contrast, $10,000 invested in the Vanguard 500 Index fund (symbol VFINX) over the same time period would be worth over $16,000 today. Operating expenses of the Natixis fund are approximately 1.61%. This compares unfavorably to the operating expenses for VFINX which are 0.18% (that is correct, a 1.43% difference).3 The track record certainly doesn’t support the hype and, based on the fund operating expenses, it looks like the only winner here is the fund company.

(The mention of the securities listed above is for explanatory purposes only and is not to be misconstrued as a recommendation for or against them.)

Stay far, far away

Stay away from these funds. You can do a much better job of managing the risk to your portfolio from a market downturn by (a) making sure that you have a comprehensive, up-todate investment plan that includes a thorough risk assessment, (b) holding a well-diversified, global equity portfolio and (c) using the fixed income portion of your portfolio to dampen the inevitable downswings in the market. Once again, Wall Street wins an Oscar for the best performance in the Charlatan category!

1 Taken from remarks made at a talk entitled “Equilibrium Markets: The Efficient Amount of Inefficiency” given at the Dimensional Fund Advisors Financial Advisor conference February 28-29, 2008

2 Taken from the prospectus for the MainStay 130/30 Core Fund, page 9

3 All performance data as of February 28, 2008 from