16 August 2007
In a story a couple of weeks ago, Morningstar analyst Todd Trubey proclaimed:
“Supporters include some investors and plenty of marketers who breathlessly describe the 130/30 structure as a breakthrough that will revolutionize investing and amp up returns. Ultimately we think that investors should understand–but look past–the hype and bring a healthy amount of skepticism to the table when judging this group.”
But unfortunately, it seems that neither Morningstar’s fund information, nor the 130/30 fund managers’ very own marketing materials, adequately cover the salient elements of these funds.
Case in point: Trubey mentions the ING 130/30 Fundamental Research Fund (IOTAX) among what he describes as a “handful” of 130/30 mutual funds in existence today.
For starters, Morningstar puts this fund in the “large blend” category. In fairness, there is no “1X0/X0″ category. But there is a “long/short” category for the growing number of funds of that persuasion. And most long/short funds actually have a long bias anyway - like, say, a 130/30 fund (check out the recent performance of these funds for proof of their high market correlation). So why not put 130/30 in that bucket?
Unable to fit short positions into its usual fund analysis framework, Morningstar seems to just ignore them. Note that all of the “Top 25″ positions in IOTAX are long positions. Perplexed, we went right to the fund’s own website. But again, no mention of shorts. Like Morningstar’s webpage, the fund’s website looks exactly like that of a traditional mutual fund. In fact, there is even a pie chart showing 96% of the fund in stocks and 4% in cash. Shouldn’t that be more like 156% in stocks and 4% cash (130%+30%-4%), we thought ?
(Without getting into too much excruciating detail here, the pie chart could refer to the total gross exposure of the fund. So, for example, long positions might be 130/160 or 81% of the fund. Or the chart could refer to the net exposure of the fund - usually, but perhaps not always, 100%. In this case, 130% long and only 25% short would throw off all the percentages since the denominator would then be 105%, not 100%. The bottom line is that you simply can’t use a pie chart to communicate the holdings of a fund that includes short positions.)
Okay, we thought, perhaps the fund aims to eventually be 30% short, but is having trouble getting there. Or maybe it just hasn’t found any good short ideas yet. Or maybe the shorts are so small they don’t show up on the “largest positions” list.
Not so, however. ING’s fund fact sheet shows that on June 30, 2007, the fund was short Industrial SPDRs (-2.69%), Murphy Oil (-2.02%), SAP (-1.61%), Travelers (-1.5%) and WellCare Health Plans (-1.42%). Far from being trivial, the SPDR actually ranks as the third largest position in the fund on an absolute basis. Yet it appears nowhere on the Morningstar or ING websites.
And it gets worse. Morningstar’s listing of the average ratios and growth metrics of the fund’s holdings borders on the absurd. How are we to interpret these ratios if they include stocks the manager hates so much he has shorted them? Further, if average “cash flow growth” was high, would that indicate that a manager was smart to go long those companies or an idiot for shorting them. Who knows? As above, we have no choice but to assume these metrics refer only to long positions - an arbitrary decision at best and misleading at worst.
Nowhere on the Morningstar or ING websites do we find any reference to gross vs. net exposure, number of stocks long vs. short, or the different market cap sizes of longs vs. shorts. We’re not even told whether the sector exposures are gross or net (of short positions). For example, the ING website says IT comprised 23.88% of the fund on June 30, 2007. But the aforementioned marketing PDF shows that the fund was actually long 23.88% and short 3.60% in the IT sector. That’s a net IT exposure of 20.28% (23.88%-3.60%), not 23.88%.
It seems ING is also not so sure how to rank their “largest” short holdings. The list of top 5 largest short positions on the fund PDF is ranked from the “most short” to the “least short”. But the list of the top 5 largest short sectors is ranked the other way around - with the “most short” sector at the bottom. More than a simple data presentation issue, this reflects the general mind-bender that is short-selling.
But kudos to ING for providing some of this data anyway. We suspect they are able to do so only via PDF since their website (like Morningstar’s website) just isn’t set up to show the myriad of new data points needed to adequately describe a fund with both long and short positions in it.
Why not change things to reflect this new reality? It appears that Morningstar feels 130/30 funds aren’t different enough from traditional long-only funds to warrant too much extra analysis or website rework. Says Morningstar’s Trubey:
“To put it bluntly, there is no magic or pixie dust involved here to separate these funds from their more traditional kin. They are chiefly distinguished by two things–leverage (essentially, borrowing money in an attempt to magnify gains) and shorting–which may seem nifty due to their novelty in the mutual fund world.”
And therein lies the central problem with the mass marketing of long/short and 130/30 mutual funds. Adding short positions and leverage is not a trivial matter. Ill-equipped websites are just the tip of the iceberg. Better investor education, suitability requirements, sales practices, and fund analysis are also required before retail investors have the information they need to properly invest in these funds. Even Trubey admits,
“…while the overall behavior of one of these funds may be very similar to as long-only peers, we believe that there are unusual risks involved that don’t show up in the statistics.”
Well…certainly not Morningstar’s statistics anyway.
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