Fidelity

New Fidelity Long Short Fund

April 10, 2008

While most of the new fund launches are ETFs these days, certain categories of mutual funds are popular breeding grounds for new old-fashioned funds. Funds that ‘short’ stock (borrow shares and sell them with the hope of buying them back at a lower price in future) are becoming increasingly popular with investors, and therefore fund companies are lining up with new offerings.

So far this category of ‘long-short’ funds is riddled with expensive but mediocre funds. Fidelity hopes to change all that with their new Fidelity 130/30 Large Cap Fund (FOTTX), launched this past week:

The main differences between a 130/30 fund structure and other funds is the use of leverage and shorting. 130/30 Funds employ a strategy of holding investments both "long" (or bought with the expectation that the stock will outperform the market) and "short" (or those borrowed and sold with the expectation that they will under-perform the market). This gives the fund manager the ability to further capitalize on stock selection skill by allowing him to fully express both positive and negative views on stocks...…Fidelity has a 15-year history of shorting stocks, mainly in institutional market-neutral portfolios.”

The fund’s minimum is an above average $10,000 for regular accounts, $2,500 for IRA’s and for purchases made through an investment advisor.

Keep in mind such a fund is NOT safer than a stock fund that is invested 100% in stocks. The core fees include management fees of 0.86% and other expenses of 0.37% for a 1.23% expense ratio BEFORE considering dividends owed on shorted stocks and other expenses related to shorting. With these fees total expenses are 1.89%. Note that dividends earned buying stocks with short proceeds is not deducted from quoted expenses so the 1.89% in some cases is a bit of an overstatement.

If this fund were to short stocks and invest the proceeds in say, government T-bills, investors could see some risk reduction as their overall portfolio would have net exposure to the stock market of under 100% (though there would still be risk the shorts would go up while and the longs down resulting in a risk profile of 100% long).

However, this fund and many like it take the proceeds of the shorts and buy more stock. This is even riskier than borrowing the 30% to buy more stocks (130% long) like many closed end funds do because there is a risk that both the shorts and the longs will lose money – in some cases an investor could have the risk profile of being 160% in stocks if the longs and shorts picks by the fund manager both perform poorly. In fact, since an investor can lose more than 100% of their money on a short, in theory this fund could approach the risk profile of being 200% in stocks, though I’m sure Fidelity would disagree with this assessment.

Risk warnings aside, this and other similar funds have a key advantage over individuals shorting stocks: use of short proceeds. Most investors not only have to keep the proceeds of the short with the broker, they may have to pay margin interest or put some of their own cash up against the short to cover the risk to the broker. Funds get to invest the proceeds of the short and put up the rest of the portfolio as collateral.

We expect this fund to perform in the top 20% of similar funds over the next year because the fees are lower than many others and Fidelity will be doing everything in its power to make sure this new small fund performs well.

For more on this new fund check out Fidelity’s website.

Schwab YieldPlus Investors Run After Fund Goes PriceNegative

March 28, 2008

Ultra short-term bond funds have been collapsing since early July 2007, and the carnage is going from bad to worse. Apparently investors in these funds - billed as slightly higher risk alternatives to money market funds - are liquidating in droves:

Ultra-short bond fund Schwab YieldPlus (SWYPX) is the latest victim of the credit crisis. It has fallen 16.8% for the year to date through March 26, ranking dead last in its category, and as a result, investors have been fleeing the fund. Assets have fallen precipitously from a high of $13.5 billion in June 2007 to just $2.5 billion as of March 20.

The fund's sizeable loss in recent months is certainly shocking, as ultra short-term fixed-income securities are generally perceived to be safe investments with minimal interest-rate and credit risks..."

Schwab YieldPlus has fallen almost 20% since late January 2008 - four times more than the Nasdaq drop during the same period - which is particularly troubling because the upside of the fund was slim - perhaps 1% more than an investor would get in a traditional low-fee money market fund. As Schwab's website notes, "the fund’s objective is to seek high current income with minimal changes in share price. " This is the type of fund an investor might park some cash they need in a few months to pay for college tuition or to buy a house - or just to avoid the risk of the stock market or even longer-term bond funds.

Ultra short-term bond funds' trouble started last year. The adjustable rate mortgage and corporate debt these funds invested in was far riskier than the investment grade ratings would lead one to believe. The current trouble has as much to do with the open-end fund structure itself as with continuing home-loan and other adjustable debt mark downs: when investors panic sell all at once the fund manager has no choice but to sell portfolio holdings at the same time to raise cash - often at lower prices than the fund thought the holdings were worth.

Sudden increased selling by fund shareholders leads to lower security prices of the fund holdings which drives the fund price or NAV down even more, which in turn leads to more fund investors selling. As many of these types of funds have "Free, unlimited checkwriting" and all have no redemption fees, there is nothing standing in the way of nervous shareholders getting out. Selling at large funds like Schwab YieldPlus can drive prices down for other funds that own the same or similar securities as well. Mutual funds in such a death spiral will not come back to their original price even if the hard hit portfolio holdings rebound in price.