Why you should avoid the latest fund fad

If you want to own a hedge fund, but aren't sure if you have the stomach for the risk - let alone the cash to invest - then the fund-management business has the answer: the 130/30 fund.

What do you do if you'd like to own a hedge fund but you aren't sure if you have the stomach for the risk let alone the cash to invest?

The fund-management business thinks it has come up with the answer: you buy a 130/30 fund and get yourself a sort of halfway house between the stability of an ordinary scheme and the racy glamour of a hedge fund.

The idea is straightforward enough. A 130/30 fund is divided into two bits a long bit and a short bit.

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The long bit involves buying shares and hoping they will go up, and the short bit is supposed to enable you to profit from share-price falls.

When you short a stock you borrow the shares from someone else, perhaps a pension fund, sell them in the market and cross your fingers and hope that you'll be able to buy them back at a lower price later. If it works in your favour, you get to pocket the difference.

These funds allow the manager to short assets worth 30% of the value of the money in the fund. The manager then uses that money to buy more shares for the long part of the portfolio. So you end up 30% short and 130% long hence the name 130/30.

Most of the long part of the fund is supposed to more or less track the market. The rest, both long and short, goes into "high conviction" ideas, shares that the managers are convinced will either go up or down more than the market.

If they love a stock they can buy lots of it. If they hate it, instead of just not buying it, they can sell it. The upshot is that you get mostly an ordinary fund with the exciting bits of hedge funds tacked on.

It's a kind of hedge fund "lite", with the important proviso that 130/30 funds do not aim to make positive returns in all markets as hedge funds do.

Fund-management companies love the idea. First it's a new concept for the UK market so it means they can think up all sorts of ways to market it. Second, as the funds are new and exciting-sounding they can charge much higher fees.

For example, they charge performance fees if they do better than the benchmark index. This means that if the index falls but they fall less they get to charge you extra.

Yes, you heard that right they lose money and they still get paid more. It doesn't get much better than that for fund managers.

Finally, 130/30 funds are a way to persuade their young rising stars to stay rather than leave to go to a hedge fund.

Being able to run a 130/30 fund should give fund managers all the fun of hedge-fund land without the precarious job status it can come with. The recent fall in the market has seen a flood of CVs from hedge-fund employees hitting the desks of Britain's recruitment consultants.

In theory, I love the idea of 130/30. I really do. It seems entirely reasonable that rather than have to sit around the place running closet tracker funds which charge active management fees but, in effect, merely track an index really good stockpickers should have the freedom and the flexibility to put their money where their mouths are.

But herein lies the problem. There aren't that many good stockpickers about. Remember last year's craze, focus funds? The idea of these was that top stockpickers would run funds that had a limited number of stocks in them say 25 to 30.

That way they would be able to really put some weight behind their best ideas and they would or so the story went outperform their benchmarks accordingly. Some really did, but most didn't. Let's face it, they don't exactly dominate the top of the league tables.

The same goes for the so-called "absolute return" funds that have been introduced over the past few years. Most have done so badly that investors would have been better off leaving their money in the building society.

The truth is that most fund managers are useless stockpickers; they should be running closet tracker funds.

Being a bad stockpicker is never a good thing, but picking the wrong stocks for a 130/30 fund can have particularly dire consequences.

Why? Because you have to pick not just shares that will go up but shares that will go down too.

Buy a bad share and you can only lose what you put in. But if you have gone short you have to buy it back. If its price falls in the meantime that's fine. You've made money as you buy it back for less and pocket the difference.

But it could also rise, and rise indefinitely. You can lose a lot more money this way.

An awful lot of youngish managers who have moved from running long-only funds to running long-short hedge funds have found this out the hard way recently.

Given all this, exactly how much freedom do we really want to give the City's "star stockpickers"?

Luke Newman, one of the managers of the new F&C UK Enhanced Alpha fund, reckons that, "assuming the manager has the ability to pick the right stocks", 130/30 funds are a great thing.

Well, clearly. But given past experience it isn't something I'm keen to assume.

Some of the funds coming your way are going to work out: Newman has been very successful as a focus fund manager, as has his co-manager, Makis Kaketsis, so they are in with an excellent chance.

However, in the main 130/30 funds increase the already high risks of your fund manager getting it wrong and charge you more for doing so.

First published in The Sunday Times 26/8/07

Merryn Somerset Webb

Merryn Somerset Webb started her career in Tokyo at public broadcaster NHK before becoming a Japanese equity broker at what was then Warburgs. She went on to work at SBC and UBS without moving from her desk in Kamiyacho (it was the age of mergers).

After five years in Japan she returned to work in the UK at Paribas. This soon became BNP Paribas. Again, no desk move was required. On leaving the City, Merryn helped The Week magazine with its City pages before becoming the launch editor of MoneyWeek in 2000 and taking on columns first in the Sunday Times and then in 2009 in the Financial Times

Twenty years on, MoneyWeek is the best-selling financial magazine in the UK. Merryn was its Editor in Chief until 2022. She is now a senior columnist at Bloomberg and host of the Merryn Talks Money podcast -  but still writes for Moneyweek monthly. 

Merryn is also is a non executive director of two investment trusts – BlackRock Throgmorton, and the Murray Income Investment Trust.