The Advantages and Disadvantages To A 130/30 Hedge Fund

Not long ago I attended a presentation at Columbia University that included a discussion on Equity Hedge funds and the percentage allocations that are popular. One of the popular allocations seems to be the 130% Long 30% Short fund. So what does this type of fund attempt to accomplish? A close examination brings to light some interesting observations.

First, what does this 130/30 break down mean? It may be easier to first look at a 100% Long only fund. A 100% Long fund means that every dollar of the assets is invested in equities. For example, if the fund had $10 million in assets, then the fund would own $10 million worth of equities (as close as reasonably possible, less commissions). Let's move from the 100% Long fund to the 130/30 fund. This fund would use leverage and would increase its Long exposure by 30% and initiate a Short position of 30%. If the fund had $10 million in assets, the fund would own $13 million in equities and simultaneously be short $3 million in equities. The leverage in this case would be 60%.

Another way to look at the 130/30 fund is to back out the leverage for a moment. In this case the fund would be 81.75% Long and 18.75% short. This is the same ratio as the 130/30 fund. The 130/30 fund is just an 81.75/18.75 fund on steroids. The important question is why do such an elaborate percentage as 130/30? If the fund is really an 81.75/18.75 fund in disguise why not just make the fund 81.75/18.75? The first reason is the potential for increased return. Instead of using only 100% of the assets, by using 160% of the funds assets the fund manager is levering the portfolio and therefor increasing potential returns. There is tremendous upside potential with this type of leverage. For example in a down market, the upside exists if the fund manager is able to pick longs that decrease less than the market and or pick shorts that go down more. If the fund managers wits exactly match the market then the fund will match the market exactly. The market and the fund will move identically.

However there is potential risk as well. The largest risk is that the extra 60% leverage goes against the manager. For instance in a worst case scenario lets say that the manager made poor picks. In this case the 130% Long positions decrease in value and simultaneously the 30% Short positions decrease in value (as the stocks the manager is short go up). Let's say that the longs go against the manager by 20% and the shorts go against the manager by 20%. The $10 million fund would drop to $6.8 million for a drop of 32%. If the fund had not used any leverage the fund would have only lost 20% and the assets would have been $8 million. In this case the manager would have been better without the leverage.

Tread carefully when using leverage. I have seen my fair share of problems arising from too much leverage and returns can definitely increase when used properly. Again it all comes down to risk management. Make the positions too big and your problems could cascade. Even if you think you are 100% Long via a 130/30 fund if there is a problem such that the extra 60% margin is really neutralized reality may be completely different if both the longs and the shorts go against you. In that case, action should be taken to lower the leverage and quickly.