Sunday, Aug. 24, 2008

Big hype does not mean you'll see payout to match

There's a fine line between being "the next big thing" and being "the next great thing." The difference comes down to success. If a new idea can deliver performance, it will be both the next big thing and the next great thing.

But until a new concept proves itself, the "next big thing" is much more likely to be like Munder Small/Mid Cap 130/30 and RiverSource 130/30 US Equity, two issues from a new genre of ordinary mutual funds taking on hedge-fund-like strategies -- and the latest pick as Stupid Investment of the Week.

Stupid Investment of the Week showcases the concerns and characteristics that make a security less than ideal for the average investor, and is written in the hope that spotlighting flawed thinking or execution in one case will help consumers avoid similar situations elsewhere.

While obviously not a purchase recommendation, neither is this column meant to be an automatic sell signal; people with the confidence in the 130/30 strategy -- who jumped into this burgeoning asset class early -- might want to stick around in the funds to see if they can prove themselves in practice.

To date, however, that has not happened, and the Munder fund (ticker MAMSX) and RiverSource (RUSAX) fund are poster children for why investors should be skeptical.

Before you can see why that is, however, you need to understand what a 130/30 fund is, and why there are roughly 100 distinct funds following this strategy, with the vast majority of those funds -- including Munder and RiverSource -- less than a year old.

Some people avoid the confusing numbers by calling this genre "hedge-funds lite," while others call their versions "limited-shorting" or "enhanced alpha" funds.

The 130/30 moniker reflects what these funds do. Typically, a 130/30 fund invests 130 percent of its assets in "long positions" -- stocks on which the manager is betting that the price is going up -- and 30 percent in short positions, where the expectation is that the price will go down.

In a short sale, the seller borrows stock and sells it on the open market, getting the cash from the sale. If the stock's share price falls, the investor buys back the shares at a lower price, returns them and pockets the difference.

The proceeds from those short sales create the extra 30 percent of long exposure. On a net basis, the extra long and the short position cancel out and the fund can claim to be "fully invested." For the average investor, however, the idea is that the extra investment, theoretically, turbocharges returns.

In a traditional fund, the manager can put money only into stocks that appear headed for takeoff. In a 130/30 fund, the manager gets to put all of his or her information to work, betting on crash landings, too, a hedge that is particularly attractive in times like these.

It's a twist on long-short funds and market- neutral funds, both of which brought certain qualities of hedge funds -- notably a purported ability to make money in all markets -- to ordinary mutual funds. Alas, the vast majority of those fund types have failed to deliver on their potential; most market-neutral funds have been unable to make decent money in all market conditions.

So when consumers come face-to-face with a new type of fund that can bet in all directions, there's a logical expectation that it will deliver superior performance in all market conditions.

On that front, this column probably could have punished the entire genre of 130/30 funds. Early this year, Standard & Poor's issued a research paper suggesting that the performance of 130/30 funds should be measured against traditional long-only benchmarks such as the Standard & Poor's 500 Index; in that race, most of the new funds have proven to be laggards.