ProShares is launching the first 130/30 ETF strategy (see Pensions & Investments article, Nasdaq article). The 130/30 ETF (CSM) will track the Credit Suisse 130/30 Large-Cap index. The Credit Suisse 130/30 index was developed by Andrew Lo (CIO of AlphaSimplex Group) and Pankaj Patel (director of quantitative research at Credit Suisse). The ETF has an expense ratio of 95 bps, with a strategy that will offer "investors a transparent, low-cost means of achieving 130/30 beta and, potentially, alpha superior to what a comparable long-only large-cap strategy would deliver over the long run." A First Trust 130/30 Large Cap ETN (JFT) based on the 130/30 strategy was released just over a year ago (see previous post, MarketWatch article).

Not familiar with 130/30 strategies? Basically, the strategy uses leverage to short poor performing stocks and then uses the proceeds, along with initial capital, to purchase shares that are expected to do well. If is a form of the general 1X0/X0 long/short strategy, although the 130/30 ratio funds have seem to generate the most interest, producing a 130% long, 30% short strategy. Investors using the strategy will often mimic an index such as the S&P 500 when choosing stocks for the strategy. You can find additional descriptions of the 130/30 strategy here and here. Lo paper here.

Keep in mind that with such strategies the managers must pick stocks to go both long and short. Often there is feeling that you are market neutral, given that you have both long and short positions, but this is not the case. While traditional hedge fund might utilize a long/short strategy that makes them market neutral (beta close to zero), the 130/30 strategy is usually compared to a benchmark, such as the S&P 500, giving 100% exposure to the benchmark. As a result, the strategies are sometimes referred to as beta-one strategies. Furthermore, if the manager gets it wrong in either, or both directions, you may end up losing more than expected. As with most funds, good management is essential, regardless of the strategy.

Given the market beta exposure, these funds are useful if you have a positive market view and you believe that the fund manager can generate alpha from the short portion of the portfolio. If your view is neutral or negative, a hedge fund with an appropriate strategy might be better. If you have a positive market view but are not confident that your manager can generate alpha from short selling, then a long-only fund, or index fund, would be best. Keep in mind that such funds also trade more often, making them less tax efficient compared to traditional long-only index funds.

Note/Update: As a follow-up, I just ran across an excellent article at Greenfaucet that also provides details about the ProShares launch, and the success, or lack of success of the 130/30 funds. Check it out here.

Actively managed mutual funds have done well this year, rising 9.9% through June 10, compared to the S&P 500, which was only up 5.3% over the same period (see WSJ article). This comes after a year in which the average stock fund was down 38.9%, dropping 1.9% more than the S&P 500. What is causing the out-performance? It appears to be growth stocks, which are up approximately 11% this year, compared to less than 1%gain for value stocks. Many widely-held tech stocks, such as Apple (AAPL), Cisco Systems (CSCO), Google (GOOG), Hewlett-Packard (HPQ), and Microsoft (MSFT) have helped juice returns. Nonetheless, even with the current out-performance, active funds are still losing business to index funds as investors continue to remember their poor fund performance in 2008 (really poor in some instances).

The Grail American Beacon Large Cap ETF is now being offered to the public. While this would normally not be a big deal, this ETF is unique in that it is being billed as the first actively managed ETF (see WSJ article). There have been other active ETFs that diverged from a specific index, but the stocks choices for the fund were generated by computer models, as opposed to having a manager pick the stocks. In the tradition of lower fees for ETF, fees will be 0.79%, lower than a mutual fund, but still higher than a typical straight index fund ETF. Like other ETFs, the funds holdings will be made public daily, similar to mutual funds. Whether the ETF will be successful will depend on whether the company can avoid front-running of large public positions, and whether or not investors, who are already skittish and getting conservative, will be willing to invest with a product and a manager with an unknown track record. If history is any indication, the outlook is not good, especially given the timing.

A new study by Mark Kritzman, president and CEO of Windham Capital Management, found that standard index funds - those with their lower fees and expenses (including transaction costs, taxes, management fees, and performance fees) - gave better returns than actively managed mutual funds and hedge funds (see New York Times article).

For his study, which is similar to past studies, Kritzman calculated the average return over a 20-year period, net of all expenses, of three types of investment, including a stock index fund with an annual return of 10 percent, an actively managed mutual fund with an annual return of 13.5 percent, and a hedge fund with an annual return of 19 percent. He used volatility, turnover rates, transaction fees, management fees, and performance fees that were based on industry averages.

His finding pointed to the problem with high expenses. The actively managed mutual fund and hedge fund each had total expenses of more than 3.5 and 9 percentage points a year, respectively. As a result, in order to break even with the index fund net of all expenses, the actively managed fund would have needed to outperform the index fund by 4.3 percentage points a year before expenses. For the hedge funds, it was even worse, with each fund needing to outperform index funds by 10 points a year. While similar studies have been done in the past, the current finding are just yet another reason that the 2-20 hedge fund model may see more resistance going forward. Managers will no doubt be asked more than ever to verify their ability to capture alpha.

Commodity index investors (ie, speculators) sold $39 billion worth of crude oil futures between the July market peaks and September 2nd, a time that saw a rapid sell-off in crude oil prices (see Independend.ie article). The analysis was once again done my Michael Masters, president of Masters Capital Management, who recently blamed speculators for driving up prices. The drop also comes at time when the IEA is forecasting lower demand, and pension and hedge funds are unwinding commodity positions, each of which have put pressure on prices. In the end, such debate may be academic as to whether we call those selling speculators (be it hedge funds, pension funds, index funds, or individual traders). Given the exposure we all have to pensions and index funds (even us retail money mortals), we all might be classified as speculators, notwithstanding the evil mustache-twisting monopoly banker image. Of course, all this talk says nothing as for whether speculators are even inherently bad for the markets in whole (see US News & World Report blog). After all, who is going to take the other side of the position when a company is looking to hedge its risk? If the market is rising or falling, will there always be the perfect number of textbook farmers and bakers on the other side of the wheat contract? Probably not. How many companies will show higher profits, or at least less loss, due to placing proper hedges? Raising margins to decrease leverage and unhealthy exposure is one thing, but making it more difficult for the market to even function is another. If we eliminate all trades and traders that don't actually plan to buy or sell the commodity, liquidity will decrease. If this does happen, individuals may find themselves living in a much riskier world, even if the price of crude seems a little less volatile day-to-day.

Jason Zweig of Money (as reported at IndexUniverse.com) was asked a question about what a young individual in their 30s should invest in. What is the single best investment idea? Buffett quickly suggested investing all they had to invest in a very low cost index fund from a reputable firm, a suggestion he has made on numerous other occasions. Buffett mentioned Vanguard in particular, the John Bogel founded company with a number of index funds to choose from. Of course, Buffett could have suggested another - Berkshire Hathaway. While technically not an index fund, or even close for that matter, it does have some of the diversification effects that an index fund would delivery, albeit Berkshire is exposed more than average to the insurance industry. Barron's also recently declared it fairly priced, after not long ago mentioning that it was a little expensive (before it pulled back). But touting his own stock would not be Buffett's style. Furthermore, Buffett is correct that an index fund would certainly track the indexes better, something that rarely seem to occur with Berkshire anymore, although I would have to run the numbers to be sure. Rather than touting his stock, Buffett is more comfortable touting the individual companies within Berkshire, along with their products - and sampling them with the freedom and joy of a school boy. Then again, I imagine $60+ billion would make you feel a little giddy at times, but how would I, or just about anybody really know.

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