Dion Money Management Blog   Money Management for Retirees and Their Families

As the old saying goes, when times get tough, the tough get going. To help you get your portfolio going in these very tough times, we’ve reviewed seven new funds from the Fidelity Investment universe.

Each promises the potential to juice your returns by boosting “Alpha,” loosely defined by Morningstar as a fund manager’s ability to add value, in the form of higher return and lower risk, when compared to the fund’s benchmark. Each new fund promises access to the kinds of investments once largely reserved for institutional investors. The first, Fidelity 130/30 Large Cap (FOTTX), offers the opportunity to mimic some of the strategies hedge fund managers use, balancing long and short positions in order to take advantage of everything Fidelity’s deep research staff knows about stocks—both good and bad. The other six, Fidelity’s Enhanced Index Funds, combine quantitative analysis with a manager’s touch in an attempt to beat their underlying indices. Here’s a look at the funds:

The long and short of it

Fidelity 130/30 Large Cap uses both long investing and short selling in an attempt to capture market gains while protecting against downturns.

Shorting a stock involves first borrowing shares from a brokerage house, then selling them on the open market and collecting proceeds from the sale. At some point, you’ll have to buy the shares back and return them to the original owner (a move known as “covering” the short sale). If the share price falls, you can buy back the shares for less than you paid, repay the original owner and turn a profit on the deal. Until that time, you can invest the proceeds of the initial sale however you wish. It’s worth noting, however, that because short-selling involves borrowing, it entails certain costs (including interest on the borrowed securities) and credit-related risks.

This structure allows the fund to invest more than 100% of its assets. Manager Keith Quinton invests 30% of FOTTX’s assets in a short portfolio, then uses the cash received from selling shorts to fund the long portfolio at 130% of assets—hence the name 130/30.

The strategy behind the model allows the manager to capitalize on stocks he likes (going long) and those he believes will struggle (shorting), thereby using Fidelity’s research to its fullest. In theory, Quinton also should be able to manage volatility better than a traditional long fund manager because part of the portfolio is likely to rise when the market falls.

Of course, the market tends to rise over the long term. FOTTX would likely benefit from that trend because of the long portfolio—though its short sales could dampen returns somewhat during bull markets.

Putting the long-short theory into successful practice requires an excellent manager with a solid strategy. Quinton, who’s had a short (since 2004) but successful run at the helm of Fidelity Tax Managed Stock Fund and Fidelity Disciplined Equity Fund, uses a computer model, ranking 4,000 large-cap names according to Fidelity’s research, recent price moves and valuation. Quinton invests long in the stocks at the top of the list—typically inexpensive stocks that exhibit momentum—and shorts those at the bottom.

The fund was launched on April 4 and thus doesn’t have a long history. Since inception, it’s about even with the S&P 500 (through Sept. 26) but lags the index by 5.2 percentage points over the past three months. The fund’s short positions appear to have helped on “Black Monday II,” as FOTTX lost 1.1 fewer points than the S&P 500 did.

At the end of May, FOTTX’s largest short position was in shares of women’s retailer Coldwater Creek, whose price is off 18.5% year to date. That investment will keep paying off as long as Coldwater continues to decline—but the nature of shorting means a rebound in the stock could weigh heavily on this fund’s returns. “Leverage can boost an investment’s positive return,” says Morningstar’s Todd Trubey in a recent article about 130/30 funds, “but it can also magnify its losses.”

Still, Fidelity 130/30 may provide a way for your portfolio to capture the market’s upside while cushioning it a bit from the possibility of further losses. And these days, improving risk-adjusted returns is more appealing than ever.

Enhancing returns

The goal of Fidelity’s enhanced funds is to outperform a benchmark index through carrying market cycles without incurring significant extra risk or volatility.

There are currently six enhanced funds: three large-cap funds, one each for value, growth and blend styles, introduced in April 2007; and one for each of the small-cap, mid-cap and international markets, launched in December. Each Enhanced Index Fund invests 80% or more of its assets in the stocks of the benchmark, but the fund uses quantitative models to attempt to better the benchmark’s performance.

Quantitative analysis, whose practitioners are often referred to as quants, informs stock picks based on numbers such as earnings, sales, assets, book value, stock price and so on. It does not measure subjective factors, such as company management or the potential for a particular market.

The Enhanced Index Funds’ managers run the stocks of their benchmark index through a proprietary computer analysis, seeking the stocks that may have the potential to provide a higher total return than the index itself. The computer models emphasize valuation, growth in sales and earnings, quality (how much net income comes from core operations), expectations for future earnings, and technical momentum in share prices.

Next, the models use “optimization techniques” to decide when and how much of a stock to buy, seeking to minimize transaction costs and limit the portfolio’s risk. The managers overweight the best stocks, as determined by the computer models, and underweight the worst. The goal: Stick close to the index, but reach for stronger returns and avoid potential blowups. For example, the fund might emphasize shares of a firm with large assets and little debt while deemphasizing stock of a company with rapidly declining earnings.

The funds, all named “Enhanced Index Fund,” and their respective indices are:

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