Not-so-super funds

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(Money Magazine) -- In a jittery market like this, when the Dow plunges more than 300 points in a single trading day and then gains it all back in another, it's anyone's guess which way stocks are headed.

But if there's one thing you can count on, it's that Wall Street will try to find a way to capitalize on your uncertainty.

Enter so-called 130/30 funds. If you haven't heard of them, you will soon - especially if this aging bull starts to deliver subpar returns.

That's because this new breed of souped-up funds, using strategies hedge funds employ, claims to have the power to beat the market indexes over the long run no matter how they perform. You believe in superheroes, don't you?

About two dozen 130/30 retail funds have been launched in recent months by companies including ING, MainStay and UBS, and more are on the way.

In addition to betting on stocks, 130/30 funds bet against some equities by short-selling a portion of their portfolio - that is, borrowing shares and selling them in the hope of paying back the original owner with stock that's declined in value.

This means they have something in common with so-called long-short funds, which also give managers the power to short and which grew in popularity in the wake of the 2000-02 bear market.

The idea in both cases: If you think your fund manager can tell winning stocks from losers, why not let him profit on both calls?

But unlike typical long-short portfolios, 130/30 funds use leverage, meaning they invest with borrowed capital or use other techniques to boost their returns. These hedge-fund-like procedures supposedly give 130/30 managers superpowers, at least compared with ordinary fund managers who can only invest "long."

But as we all know, with great power comes great responsibility - and even greater opportunities to fail.

Here's how the strategy is supposed to work: A 130/30 fund manager will bet on the stock market by investing, say, $100 on a collection of stocks - typically, shares of U.S. blue-chip companies.

For every $100 he invests in shares he thinks are set to rise, the manager will short $30 in stocks he thinks are overvalued and will fall. The manager will then take the proceeds of his short sales and invest another $30 on stocks he thinks will climb.

The result: a portfolio with $130 bet on equities for every $30 bet against them. Hence the name 130/30. (There are a handful of 120/20 and 140/40 funds that utilize the same concept but rely on a different mix of long and short positions).

Because these funds have a net 100 percent exposure to equities, they claim that they're not much riskier than traditional stock funds that don't short.

The only hitch so far is that there's little evidence that this strategy works.

Granted, just six retail versions of these funds have been around for more than a year. But on average they gained only 2.4 percent this year through Nov. 9, according to Morningstar. Compare that with the 4.1 percent returns you'd have earned in the mere mortal S&P 500 index.

And while you'd think they'd be able to navigate a market storm - in part because of their ability to short - 130/30 portfolios have looked downright pedestrian in recent months.

Between July 19 and Aug. 15, for example, when the S&P sank 8.9 percent, the average retail 130/30 fund fell 11 percent.

It's not surprising that these funds haven't lived up to the hype. Unlike with a traditional stock fund, a 130/30 portfolio manager has to get two things right: the stocks he thinks will rise and the securities he's betting will fall. If that isn't hard enough, because these funds use leverage, any mistakes will be amplified.

"With a 130/30 fund, you're simply upping the stakes in your bet on an active manager," says Rick Ferri, an investment adviser in Troy, Mich. "And there's little reason to believe many managers can successfully beat the market by going long, let alone going short."

There are also costs to consider. The average 130/30 fund charges 1.4 percent, which is comparable to a typical stock fund. But these funds often trade stocks at a much faster pace. And rapid trading pushes up transaction costs, which may reduce your returns by an additional two percentage points or more a year - while also boosting your tax bill.

"Given the results so far, there's no reason for most investors to rush into these funds," says Morningstar analyst Marta Norton.

Despite the shortcomings of 130/30 funds, there are certain elements of a long-short strategy without the leverage that have some appeal.

After all, a fund that shorts is going to be run by a management team that's a bit contrarian and less likely to throw money at overvalued stocks just because they're going up. And because they're shorting, the funds don't move in perfect sync with the rest of the market.

That's why some advisers are putting long-short funds into their clients' portfolios. Still, they're allocating only a small percentage of assets and are proceeding cautiously.

"Investing in these funds requires a long-term view and lot of due diligence," says Pittsburgh financial adviser Lou Stanasolovich.

Yet the fact remains, you can achieve the same goals without having to hedge your stocks with, well, other stocks. "It's all about asset allocation," says investment adviser Bill Bernstein of Efficientfrontier.com. "If you want to diversify against the risk of stocks, the easiest way is to add more fixed income to your portfolio."

So instead of investing in an unproven long-short or 130/30 fund, you might consider a traditional moderate allocation, or balanced portfolio, such as Vanguard Wellington (Charts).

This fund holds roughly 60 percent of its assets in stocks and 40 percent in fixed income. Its expense ratio is just 0.30 percent, which is a fraction of the cost of an average long-short fund. And over the past five years this fund returned 12.4 percent annually vs. 12.2 percent for the S&P, which is stellar considering its significant exposure to bonds.

Even better, during the recent stock market meltdown from mid-July to mid-August, the fund lost only 5.6 percent, which was 3.3 percentage points less than the S&P 500 fell.

Meanwhile, if you like the fact that long-short funds try to avoid overvalued stocks, why not simply invest in high-quality value-oriented equity funds run by managers who shun expensive shares? Good examples abound.

For instance, you might consider the Sound Shore (Charts), Fairholme (Charts) and Janus Mid Cap Value (Charts) funds. All three portfolios are in the Money 70, our list of recommended mutual funds and ETFs.

Granted, given the recent turmoil in traditional value sectors of the market like financial stocks, some bargain-hunting funds haven't looked that super in the recent market sell-off. But over the long run, a low-cost value-oriented portfolio should be heroic enough.

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