How Do You Benchmark a 130/30 Mutual Fund?

Back in December I wrote about a type of mutual fund known as the 130/30 fund which I believe will be coming to Canada in the next few years. In a nutshell a 130/30 mutual fund allows a fund manager to not only go long the stocks he/she thinks will go up, but to also short the stocks that he/she thinks are over-priced. Every dollar invested goes into the long stocks and then the manager will short some stocks (equivalent to 30% of the money invested). When you short a stock (selling a stock you don’t own), you still receive the sale proceeds. So now the manager has another 30 cents to play with, which he/she uses to go long more stocks. Hence the name 130/30. You can read my original post from back in December by clicking here.

Mutual_fund.jpgThere has been some debate as to the best way to benchmark these funds’ performance. Standard and Poor’s indicated that they were going to launch coverage of the US 130/30 index by creating a screen for what stocks to be shorted by using the lowest 30 rated stocks of the S&P500 according to their proprietary STARS stock rating system and factor in their inverse performance into 130% of the S&P500 index. However, I came across this very interesting white paper from Standard and Poor’s in which the authors conclude that the actual best benchmark to use would be the plain vanilla S&P500 index (or in Canada the S&P/TSX Total Return Index), and I am inclined to agree. The paper includes the CFA Institute’s views on the criteria necessary for a proper benchmark in the paper, and the authors do a fine job supporting their conclusion. You can read the S&P’s white paper by clicking here (PDF Download).

I believe that the peer group performance of the 130/30 funds for each respective index in which they operate needs to be tracked so that you can compare each 130/30 fund to it’s competitor, but then to use the plain index as the relative benchmark to assess if this structure is indeed providing alpha. After all, not only are you asking the fund managers to pick winning stocks (and there are many studies to show that this is hard enough), you are throwing in another variable into the mix by having them try to pick the losing stocks as well.

Preet Banerjee
Preet Banerjee an independent consultant to the financial services industry and a personal finance commentator. You can learn more about Preet at his personal website and you can click here to follow him on Twitter.
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  • The Deal Sleuth

    Note that the 130/30 manager can not utilize all the proceeds of the short sale to buy longs, because the broker must retain at least some of it. As a result, the manager must borrow to acquire the equivalent amount of stock that was sold short. The spread between the borrowing cost and the short rebate can affect returns quite significantly, as
    this post by The Deal Sleuth shows.

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  • […] Well, really the benchmark of ANY strategy is its opportunity set but I thought I would use the 130/30 funds as an example. I have written before about what 130/30 funds are, and how the appropriate benchmark for such a strategy would be the plain van…. […]