Should part of a 130/30 fund count toward a portfolio’s hedge fund maximum?

Many institutional investors impose a maximum percentage of the portfolio that may be in hedge funds.

Suppose the investor holds a 130/30 fund, a vehicle that is 130% long and 30% short stocks. Should part of the 130/30 fund count as a “hedge fund” toward the portfolio maximum in hedge funds?

This piece will use a simple universe to illustrate the differences among traditional long-only funds, hedge funds and 130/30 funds.

Assume a universe with only two stocks: an undervalued stock, Cheap Co., and an overvalued stock, Expensive Co.

Suppose a traditional long-only fund has $100; a hedge fund has $30; and a 130/30 fund has $100.

If all three funds realize that Cheap Co. shares are undervalued and Expensive Co. shares are overvalued, the following likely would happen:

• the traditional long-only fund would buy $100 of Cheap Co.;

• the hedge fund would buy $30 of Cheap Co. and sell short $30 of Expensive Co.;

• the 130/30 fund would borrow an extra $30 to buy $130 of Cheap Co., and sell short $30 of Expensive Co.

(This example is a variant of one in a Merrill Lynch Global Asset Managers publication, “130/30 Portfolios — Here Comes the Wave.”)

An institution's investment of $100 in a 130/30 fund is roughly equivalent to using $100 of its own money and borrowing $30 to obtain $100 in a traditional long-only fund and $30 in a hedge fund.

Some institutions might consider an investment of $100 in a 130/30 fund as equivalent to $100 in a traditional long-only fund. This is misleading in at least two important respects. First, it conceals the 130/30 fund's borrowing of $30 (an amount indirectly borrowed by the institution). Second, the treatment hides the de facto $30 investment in a “hedge fund.”

Suppose an institution is the only investor in the 130/30 fund above. Assume that the entity imposes a ceiling on the percentage of its portfolio in hedge funds. For the purpose of that restriction, the institution should treat the $100 invested in the 130/30 fund as follows:

ASSETS: $100 in traditional long-only fund and $30 in a de facto hedge fund

LIABILITIES: $30 in indirect debt


Thirty dollars should count toward the maximum in hedge funds. This is more transparent than treating $100 in a 100/30 fund as equivalent to $100 in a traditional long-only vehicle.

William K.S. Wang is a professor at the University of California, Hastings College of Law.