130/30 Strategy Explained
Many hedge funds use long-short strategies in order to profit in both rising and falling equity markets. By maintaining both short and long positions, investors can reduce market risk within their portfolios and increase risk-adjusted returns. Short position gains in falling markets help offset losses in long positions and vice-versa, while a tendency to hold overvalued shorts and undervalued longs creates alpha.
In this article, we’ll take a look at the so-called 130/30 strategy, which is designed to create an optimal long-short portfolio and realize many of these benefits.
What Is the 130/30 Strategy?
The 130/30 strategy involves short-selling stocks up to 30% of a portfolio’s total value that the trader believes will underperform the market and then using the proceeds to take a long position in stocks the trader believes will outperform the market. For example, a trader might invest 100% of a portfolio in the S&P 500 and short-sell the bottom ranked stocks and reinvest the 30% for a 130% exposure.
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Let’s take a look at a quick example of this process:
- A fund raises $1 million and buys $1 million worth of securities, making it a basic run-of-the-mill 100% long-only fund.
- The fund borrows $300,000 worth of securities and sells them with the agreement to repurchase later, giving it a 30% short position.
- The $300,000 in proceeds from the short sale are used to buy $300,000 worth of additional long securities, making the fund 130% long.
- The end result is a fund that has $1.3 million (130%) in long securities and $300,000 (30%) in short securities, making it a 130/30 fund.
Since many 130/30 traders invest in large-cap equities or indexes, the strategy can be considered a core asset rather than an alternative asset in most cases. The difference between traditional hedge fund and 130/30 strategies is that the latter is managed against specific benchmark indexes that underlie the portfolio rather than speculating on specific securities as many hedge funds try to do.
According to some studies, the 130/30 structure captures about 90% of the benefits of leverage, while eliminating many of the risks. Those skeptical of 130/30 funds call the idea more of a marketing gimmick than a proven strategy, pointing out that many traditional long-only funds have outperformed their 130/30 counterparts over time (it should be noted that 130/30 became popular circa 2007, however).
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Benefits of the 130/30 Strategy
The major benefit of the 130/30 strategy is the ability to profit from the bottom quartile of equities. Whereas a long-only investor would simply ignore these stocks, traders using the 130/30 strategy have the flexibility to profit from their decline. Even modestly outperforming long-only investors can produce substantial compounding benefits for traders using the 130/30 strategy over time.
A second major benefit is being able to profit during bear markets, since short positions gain value as an equity declines. While long-only investors must wait on the sidelines for a market recovery, those using the 130/30 strategy can hedge their portfolio against a market decline and even profit in some cases. These dynamics can improve overall risk-adjusted returns over time.
After all, Wall Street’s prime brokerage business has been largely powered by the growth of hedge funds, partly due to their profitability using short positions. Short selling and the leverage it employs may be a double-edge sword, but competent managers employing tried-and-true strategies may be able to generate consistent alpha over time, just as many hedge funds have managed to do.
Who Should Use the 130/30 Strategy?
Many traders can benefit from the 130/30 strategy given its unique neutral market exposure and relatively risk-free nature compared to traditional short selling. In some ways, the 130/30 strategy provides Main Street investors with a way to access strategies that have been the hallmark of hedge funds – which have been limited to high net worth individuals due to their riskier nature.
Some market participants that could benefit include:
- Long-Only Investors. Investors seeking to increase diversification and return potential by expanding into short selling without the traditional risks associated with short-only or short-heavy strategies.
- Foundational Investors. Investors looking to build exposure to a diverse number of large-cap U.S. companies may benefit from exploring the 130/30 strategy as an alternative to simply purchasing low-fee funds.
- Tax Advantaged Accounts. Investors that don’t want to incur current year taxes on frequent trading—typical for 130/30 strategies—may want to consider avoiding the strategy to save money.
Some popular mutual funds and ETFs utilizing the strategy include:
Risks and Other Considerations
The majority of 130/30 funds became popular during 2007, just before the credit crisis made short selling enormously difficult and expensive. Since then, the number of 130/30 funds has thinned out significantly and the remaining funds have been struggling to recover from the crisis. Traders and investors should carefully consider their risks before making any investment decisions.
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Some key risks and considerations include:
- Limited Track Record. Most 130/30 funds have a very limited track record, since most of them began back in 2007. The majority of funds that began then also ended up folding due to the 2008 economic crisis.
- Efficient Market Hypothesis. Many long-only investors believe that minimizing fees represents the only way to generate long-term alpha, proven by the fact that most fund managers underperform the major indexes.
- Leverage Increases Risk. The use of leverage increases volatility in most cases, which leads to a higher beta-coefficient and greater risk. These levels of volatility are important for investors to consider.
- Higher Fees & Turnover. Most 130/30 funds use active investment strategies, which means that they tend to have higher turnover (bad for tax purposes) and greater expense ratios than index mutual funds.
The Bottom Line
So-called 130/30 funds have had a rough start since they became popular in 2007, but the survivors from that time provide traders and investors with a unique opportunity. By taking both long and short positions, the funds act similar to hedge funds in their ability to generate leveraged returns and protect against downside risk, but choosing the right manager remains more important than ever.
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