What is the 130-30 Strategy?

Hedge funds often use long-short strategies to leverage stock market fluctuations. By holding both short and long positions, investors mitigate market risks in their portfolios and increase risk-adjusted returns. Profit from short positions in the down market helps offset losses in long positions and vice versa.

In this article, we’ll take a look at the meaning of the 130/30 strategy, along with its associated risks and benefits.

The 130-30 Strategy?

The 130-30 strategy definition is an investment method used by institutional investors similar to the long-short equity strategy. The 130-30 strategy shorts stocks that traders believe will underperform the market, but only up to 30% of the total portfolio value. Then, using these proceeds to take a long position in stocks they believe will outperform the market.

How does the 130-30 strategy work?

In the 130-30 strategy, investment professionals rank the stocks in the S&P 500 from highest to lowest expected return, based on past performance. They use a plethora of data resources and rules to rank individual stocks. Stocks are typically ranked according to specified selection criteria over a set period of 6 months or a year. The selection criteria could involve total returns, risk-adjusted performance, or relative strength. The stocks are then ranked best to worst.

From these best-valued stocks, the investment manager invests 100% of the portfolio value and shorts the lowest ranking stock, up to 30% of the total portfolio value. The money earned from short sales can be reinvested in the highest-ranking stocks, thus allowing a way to increase the investor’s exposure to top stocks.

Example of how 130-30 funds work

An investor fundraises $1 million and buys $1 million worth of securities, making it a simple 100% long-only fund. The fund borrows $300,000 worth of securities and sells them while agreeing to buy them back, leaving a short position of 30%. The $300,000 short sale revenue will be used to purchase an additional $300,000 worth of long securities, making the fund 130% long. The result is a fund with $1.3 million (130%) of long securities and $300,000 (30%) in short securities, therefore resulting in a 130-30 fund

Many 130/30 traders invest in large-cap stocks and indices. Thus, in most cases, the strategy can be seen as a core investment rather than an alternative investment. The difference between traditional hedge funds and the 130-30 strategy is that the latter is managed against a particular benchmark index that underlies the portfolio, rather than guessing about security as many hedge funds try.

According to some studies, the 130-30 structure gains about 90% of the leverage benefits while eliminating many risks. Those sceptical of the 130-30 fund call it a marketing gimmick rather than a proven strategy. Additionally, touching upon that many traditional long-only funds surpass the 130-30 fund over time.

Benefits of 130/30 Funds

• The chief advantage of the 130-30 strategy is profiting from the lower ranking stock. Long-only investors may ignore these stocks, but traders using the 130-30 strategy are flexible towards benefitting from their decline. Even for long-only investors who are slightly outperforming, the 130-30 strategy can create significant compounding benefits over time.
• The second big advantage is that you can make a profit in the bear market, as the value of the short position will be higher when the stock declines. Long-only investors have to wait around for the market to recover. However, investors using the 130-30 strategy can protect their portfolios from market downturns and potentially even profit. Over time, this dynamic can improve the risk-adjusted returns.

Shorts and the associated leverage may be double-edged. As many hedge funds should achieve, skilled managers who employ proven strategies can generate consistent alpha over time.

Should you use the 130-30 strategy?

Traders can benefit from the 130-30 strategy due to its neutral market exposure and relatively risk-free nature, in contrast to traditional short sells. The 130-30 strategy provides small investors with a way to access the strategies that characterize hedge funds, which are otherwise limited due to the high net worth and high risk involved.

Certain market participants that could gain from the 130-30 strategy include:

• Long-only investors: Investors who seek to increase the potential for diversification and return by shorting without the traditional risks associated with short-heavy strategies.
• Foundational investors: Investors seeking to gain exposure to a variety of large-cap U.S. companies can additionally benefit from the 130-30 approach as an opportunity to without a doubt shop for low-fee funds
• Tax-advantaged accounts: Investors who do not want to pay year-to-date taxes on frequent transactions should consider avoiding this strategy to save money.

Risks and other considerations

The majority of 130-30 funds gained popularity in 2007, before the credit crunch made short sales cumbersome and expensive. The number of 130-30 funds has declined significantly since, with the remaining funds struggling to recover. Traders and investors need to carefully consider all risks before making an investment decision.

Some of the key risks and considerations include:

• Limited track record: Most 130-30 funds were launched in 2007 and have a very limited track record. Most of the funds raised at that time ended due to the economic crisis of 2008.
• Efficient market hypothesis: For many long-only investors, minimizing fees is the sole way to generate a long-term alpha, as evidenced by the fact that most fund managers underperform key indices.
• Higher rates and sales: Most 130-30 funds use active investment strategies. In other words, they tend to have a greater turnover (leading to higher taxes), and higher expense ratios than index mutual funds.
• Leverage increases risk: Leverage increases volatility, leading to a higher beta factor, and higher risk. These volatility levels are important considerations for investors.

Final word

The 130-30 strategy offers investors and traders a unique opportunity. Taking both long and short positions, the funds act just like a hedge fund in terms of their potential to generate leveraged returns and guard against downside risk. However, employing a proficient financial manager to assess the risks is essential.