Can This Hedge Fund Trick Boost Your Returns?

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Sometimes investing seems so simple. Buy stocks that will outperform their competitors. Avoid stocks that will underperform, or even better, sell them short. Then sit back and watch the money come pouring in.

That's the general idea behind the hedge-fund strategy that one new ETF has adopted as its investment strategy. With the latitude both to own stocks as well as sell them short, this fund hopes to build a competitive advantage over more traditional ETFs and usher in a new wave of funds with strategies taken in part from the hedge fund world.

Using the 130/30 strategy
The ProShares Credit Suisse 130/30 ETF (CSM) began trading earlier this week. As its name suggests, its investment objective involves using what's known as the 130/30 strategy to make investments.

The idea behind the 130/30 strategy is simple. Rather than simply looking for the best stocks to own, you also look for companies you believe are going to perform badly. For every $100 million in assets the fund gets, it sells $30 million in shares short, and then takes both the original $100 million as well as the $30 million in proceeds from the short sales and buys stock in the companies you believe will perform best.

In the case of the ProShares ETF, the fund chooses which stocks it will buy and sell short based on an index developed by Credit Suisse. According to the ProShares website, as of June 30, the index included long positions in ExxonMobil (NYSE: XOM), Procter & Gamble (NYSE: PG), and JPMorgan Chase (NYSE: JPM). Offsetting the fund's long portfolio were short positions in Nicor (NYSE: GAS), SLM Corp. (NYSE: SLM), and Keycorp (NYSE: KEY).

Obviously, the way to make the most money using the 130/30 strategy is to pick winning stocks for your longs, and find big losers for your short sales. Nevertheless, if you only pick average stocks in both your long and short portfolios, you should at least come close to matching the market's overall return, albeit with some extra expenses potentially coming from the short-selling.

In practice, though, it hasn't been nearly as easy to follow through on that strategy as you might think.

Falling short of expectations
The ProShares fund isn't the first exchange-traded product ever to adopt the 130/30 strategy. The Keynotes First Trust Enhanced 130/30 Large-Cap ETN (JFT) launched slightly over a year ago. So far, its results have been terrible, as the ETN has a one-year loss of almost 47%, far worse than the 24% drop in the S&P since this time last year. The index it tracks recently had Teck Cominco at the top of its ownership list, with Applied Materials (Nasdaq: AMAT) at the bottom of the list of shorts.

In addition, several traditional mutual funds have used the strategy. Some have fared better than the Keynotes ETN, but none managed to avoid most of the brunt of the downturn in 2008, and some have done badly in 2009 as well. Moreover, some of these funds carry hefty front-end sales loads, and because most of them have failed to gather substantial amounts of investor assets, they tend to have fairly sizable expense ratios.

What to do
By itself, the failure of 130/30 funds to deliver good returns last year doesn't necessarily mean that you should give up on the strategy entirely. Remember that because these funds still have a net stock position that's 100% long, you can't expect them to make money when stocks are down sharply overall.

Also, many formerly strong investment strategies have had trouble in the recent market environment. In particular, some of the biggest bounces since March have come from relatively weak stocks that many might choose to be good short candidates. Failing to avoid short squeezes and big turnarounds can hobble a fund that short-sells the wrong stocks.

More than anything, new ETFs let you look closely at strategies you haven't encountered before. The transparency that ETFs provide can teach you a lot about exactly what such funds do and how they make changes to their investments in response to changing market conditions. So don't count on them to make you rich, but watch how they work, and learn from their successes and failures. Even if you never buy a single share of a 130/30 ETF, you can still learn a lot just by keeping your eyes open.

For more on using funds and ETFs, read about:

• These funds could make you a millionaire.
• Is a recovery right around the corner?
• This is the easiest way to gamble your money away.