130/30 Funds may be Coming to Canada
Understanding how these new Financial Products Work
Aug 28, 2008
A 130/30 fund is a managed mutual fund which exposes your portfolio to leverage in an innovative way. For every $100 you invest in the fund, the manager will buy $130 worth of stock and "sell short" $30, keeping your net market exposure at $100 while providing an overall total market exposure of $160.
"Short selling" is the process of buying a stock with the expectation that it will fall in price. In a short sale, the stock is borrowed and then sold, with a plan to buy it back at a lower price in the future and return it to the lender.
How 130/30 funds work
130/30 funds can be constructed in a number of different ways. The $100 portion can be invested passively, in a bundle of stocks that mimic the overall market, with only the $30 portion actively managed; or the whole $130 can be actively managed, using individual stock picks, in expectation of beating overall stock market performance.
In either case, your money is exposed to both the manager's influence and to leverage (the use of borrowed money), without you having to make stock picks and short-selling decisions on your own.
Understanding the benefits
These funds, while not yet available in Canada, could offer potential benefits to Canadian investors.
The primary benefit is that investors get the benefit of leverage while limiting their exposure to liability for losses. Because these investments are structured as mutual funds, any investor's liability is limited to the amount of their original investment.
In contrast, when do-it-yourself investors use leverage, they are liable for the entire $160 when they replicate a 130/30 structure.
Be aware of potential drawbacks
There are some pitfalls which these funds may encounter. One of them is the relative scarcity of stocks available for borrowing. If 130/30 funds come into Canada in a big way, the cost to borrow stocks will rise as the competition for stocks available to borrow rises.
The requirement for active management of these funds also adds an extra cost layer, when compared to a purely passive investment such as an Exchange Traded Fund or even a standard mutual fund with no leverage exposure.
Finally, it is important for investors to understand that the use of leverage provides enhanced ups and downs to stock market returns. If the manager of the 130/30 fund you select does well, you stand to benefit with returns that surpass general market returns - but if the manager's picks underperform, you have additional exposure to those negative returns.
To learn more
For the time being, 130/30 funds are not available in Canada, and there are regulatory complexities regarding short sales in Canada which must be overcome if these funds are to debut here. However, if you are interested in learning more about 130/30 funds, check these articles:
For an overview of the strategy upon which these funds are built, try Investopedia
For a Canadian perspective on 130/30 funds, try this article from Advisor.ca
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