After the financial Chernobyl of 2008, "leverage" is almost a four-letter word. Even people who aren't quite sure what leverage is know it's somehow associated with the sort of speculative meltdown that produces the occasional Black Tuesday and maybe ruins the economy of a Nordic country or two.
Actually, leverage, like an after-work martini, is nothing to be feared if used sensibly. Simply defined, it's the art of using a little bit of money to control a lot of assets. If you've borrowed to buy your house, you own a leveraged investment—one that neatly demonstrates the amplifying power of leverage. If you'd bought a $100,000 house with cash and it rose 10 percent in value, you'd obviously have a 10 percent gain on your capital. If, however, you'd put down $10,000 and borrowed $90,000, you'd have a 100 percent gain.
Of course, leverage works both ways: If the price of your house fell 10 percent, you'd have a 100 percent loss on your capital. Indeed, the risk of amplifying losses is what makes many people wary of leverage.
You don't have to be a giant hedge fund whose every dollar is matched by 200 borrowed dollars to exploit the power of leverage (though the record suggests that if you are, you stand a much better chance of being bailed out by the Fed). Retail investors can benefit from leverage too.
Within the universe of "alternative" investments, there are so-called 130/30 funds that provide just that. Also known as "active extension," "short-extension" and "hedge funds lite," they work by betting not just that certain stocks will rise, but also that others will fall. They're known as 130/30 funds, after the most common ratio of "long" positions (bets that stocks will rise) to "short" positions" (bets that they'll fall) these funds adopt. Actually, "130/30" is a generic descriptor for funds with ratios that run anywhere from 110/10 to 150/50—the maximum allowed by the Securities and Exchange Commission.
In simplified terms, here's how they work: A fund manager buys $100 worth of stocks he thinks will rise, then borrows and sells $30 worth of stocks he thinks will fall (a textbook example of "short-selling"). He uses the proceeds of the short sale to buy $30 more in long positions, leaving the fund with $130 in long positions and $30 in short positions. Subtract the short from the long and you end up 100 percent net long, although with $160 in total investment positions poised for gains if the manager's picks prove correct.
The idea behind the 130/30 fund is that it frees an astute fund manager from the so-called long-only constraint that applies to most mutual fund strategies. A long-only fund manager can't do much to exploit stocks he thinks will fall, except underweight (relative to a reference index, which most funds use) or avoid them altogether. In a 130/30 structure, though, managers can actually profit from shorting these stocks. Because the fund remains 100 percent net long, the theory goes, investors get more upside potential without a lot more risk.
As a strategy, though, the 130/30 model has had a wildly checkered track record. Most 130/30 funds available to retail investors have been around for less than 10 years. New 130/30 funds were coming out of the woodwork in 2007-08, but many closed soon after the market meltdown of 2008-09. Today, Lipper lists just 18 mutual funds using the strategy.
Performance hasn't been exactly reassuring. One thing to know about 130/30 funds is that they are not intended to provide downside protection, a tempting assumption given that they short stocks. In fact, a Morningstar report from April 2009 shows that 10 130/30 funds collectively did worse than their long-only counterparts during the severe bear market that had just bottomed out. The 130/30 funds fell 43 percent, compared with 41 percent for the long-only funds. The performance was measured from the inception of the respective 130/30 fund, but none was more than two years old.