130/30 Fund Structure

Christiaan Wiebols 26.03.2012

Investments- Problem Set 5

Question 1

The most obvious advantage of the 130/30 fund structure is that it allows to short sell and by doing so, allows for more flexibility in turning new information into gains. In a long-only fund a structure, a fund is only allowed to bet on positive market information whereas a fund structure that allows both shorting and longing, the fund can bet on both negative and positive information. This is common in quarterly financial reports of traded which companies whose information can have a broad impact on the price of the stock, both negatively and positively. Thus short-selling gives the investor greater managerial flexibility. Another advantage of shorting is levering. By borrowing through short selling, the investor can use the newly acquired capital to increase long positions in case the investor is confident about his investment and he could make a larger turnover. By looking at Exhibit 4, it shows that "911 stocks (91%) had weights less than 50 basis points (bps), 1 and 775 stocks (78%) had weights less than 10 bps" in the Russell 1000 Index. This means that most stocks had a very small weight and therefore, the limits to the gains a long-only fund structure could achieve were very constrained. If for example, an investor who was actively replicating the index would have negative information about a certain stock within that index, the most he could do in response to this new information is underweight that stock so the gains (lack of losses) he could make are just limited to the weight of the stock on the index. About taxation, a strategy could be built that wasn't taxed more than a long-only strategy. This was due to the fact that the investor could avoid any extra "debt taxes" by obtaining the extra money from shorting other stocks. A direct disadvantage of allowing for short selling is that it can be very risky. When shorting, there is no limit to the losses one can make. When longing,...