130/30

So what is the 130/30 strategy?

Let's start at the beginning. The "Alpha".

I am not referring to the first letter of the alphabet or the biggest gorilla in the troupe. In finance, alpha has a different meaning.

It is a measure of how well an investment, usually a mutual fund, performs in comparison to the overall market. In an oversimplified example, if the whole market goes up 10% and your specific investment goes up 10%, then the alpha of that investement would be zero.

Things get a little more complicated because Alpha also considers the relative risk of whatever stocks are being bought. If a fund manager invests in stocks that are very stable (i.e. prices don't fluctuate too much), the alpha is calculated differently than if the fund manager invests in very volatile stocks.

Conventional wisdom states:
Stable stocks are safer - volatile stocks are riskier.

Therefore, if one invests in risky stocks, the potential profits should be higher. Alpha takes that into consideration. A mutual fund specializing in nanotechnology start ups would have to deliver much higher profits than a collection of blue chip mega-corporations to get the same "alpha" ranking.

So, getting back to 130/30. The goal is to increase the alpha while maintaining low volatility. It works like this:

Let's assume $100 investment.

1. Buy $100 of large cap stocks
2. Sell short $30 of the stocks in your portfolio
3. Take the proceeds of the short sale and buy more large cap stocks.

Confusing? Just a bit. Selling short is like betting that a share price will go down. How this is achieved can be complex and possibly another post on the blog. These days, shorting often involves trading of options and derivatives. The important thing to know is that the more a stock falls, the more profit the investor makes.

The tacit assumption is that the managers of the 130/30 fund are good at picking winner and loser stocks. Ultimately, that is going to determine performance.

The cool thing is that this strategy limits losses when markets turn downward. This is how risk is reduced, without sacrificing performance. It could limit profits in a crazy bull market. But in the long race, it is often profitable to bet on the tortoise, not the hare.