A New Way to Beat the Market?

To beat the market, mutual fund managers often ramp up risk, making outsize bets on stocks they expect to outperform. Now some quant jocks say they’ve hit upon a less risky approach: A strategy called 120/20, which, ironically, combines two risky strategies, leverage and short sales.

Until recently, this strategy was available mainly to institutional investors. But this year, companies such as Goldman Sachs (GS), ING (ING), and Merrill Lynch (MER) have incorporated it into mutual funds and separately managed accounts. Some $36 billion is in 120/20-type programs, up from virtually nothing three years ago, says Harindra de Silva, president of Analytic Investors, a Los Angeles money manager that offers three such mutual funds.

The goal is to beat a benchmark, such as the Standard&Poor’s 500-stock index, by as much as three percentage points a year after fees, says de Silva. Even a single percentage point can make a big difference. For example, in the 10 years ending Sept. 30, the S&P 500 earned a compounded average annual growth rate of 8.57%, so a $10,000 investment grew to $22,756. Add a percentage point per year and the total comes to $24,941, or nearly 10% more. “In a low-return environment, this type of enhancement is compelling,” de Silva says.

It’s too soon to know if 120/20 funds can deliver since few have much of a track record. De Silva’s Old Mutual Analytic U.S. Long/Short (OADEX), which adopted the strategy in February, had beaten the S&P 500 by 1.6 percentage points by Nov. 24.

Short Stuff

Here’s how it works: For every $100 the manager invests in stocks, he sells “short” $20 worth of stocks on which he is bearish, making a bet these stocks will fall. The manager then invests the proceeds from the short sales in his bullish picks, amplifying those bets. As a result, a 120/20 portfolio has about 100% of its money in the market. (Some managers build 130/30 or 135/35 portfolios, pushing short sales to 30% or 35%.)

Money managers say the strategy can enhance returns for two reasons. First, they can make money not just on stocks they like but also those they don’t like. Second, they can put even more money to work in their top picks. That improves payoffs, provided the picks are on target.

Backers say these portfolios, if constructed properly, expose investors to just a bit more risk than they’d get with an index fund. The reason: While they can magnify their bets, they’re also hedged. For example, a manager with a heavy allocation in Target (TGT) might short shares of a rival, say, Wal-Mart (WMT). The assumption: If Target falls, Wal-Mart will fall further. In that case, profits on the short position in Wal-Mart would help offset losses on Target. The risk, of course, is that the manager is wrong, and Target falls as Wal-Mart rallies. Interested? Watch how the funds perform. Until they prove themselves, says Todd Trubey, an analyst at Morningstar, “there’s no reason to jump in.”

Curbing Risk With Risky Plays

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