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130/30 Guide

 

Words of caution for investors

These products are still relatively new to the market and they have not yet established anything like a solid track record. But there is no shortage of interest in them in investment circles, albeit tempered by adegree of scepticism.

The scepticism hinges partly on the downside risks when a fund manager gets it wrong. With long-only funds, the potential loss is limited to the amount of the original investment: in effect, when it's gone, it's gone. By contrast, the potential loss on short positions is uncapped. When, against expectations, a shorted stock rises not only does the anticipated profit not materialise – as it goes higher, it moves the short position into loss, and there is theoretically no constraint on how high this can go.

Let us also remember that the extra leverage that shorting brings to the mix can work in both directions: if it boosts returns by increasing a fund's participation in the upside, it has a similar gearing effect when the market is heading south.

The key to this strategy is that managers must know the securities they are dealing with, and this is doubly crucial when taking short positions. Long-only managers do not necessarily have adequate shorting skills, and it is no coincidence that hedge fund managers with experience in this area find themselves targets for recruitment.

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