# Understanding the 130-30 Strategy: Investing Benefits & Risks

## What Is the 130-30 Strategy?

The 130-30 strategy is a long/short equity strategy used by institutional investors. It allocates 130% of starting capital to long positions and shorts poor performing stocks for the required 30% extra investment. The 130-30 strategy targets capital efficiency with financial leverage by reinvesting the shorting proceeds in top-performing stocks. Investors often mimic indices like the [S&P 500](https://www.investopedia.com/terms/s/sp500.asp) to select stocks for this strategy.

### Key Takeaways

*   The 130-30 strategy uses financial leverage by shorting poor-performing stocks to buy shares expected to yield high returns.
*   Investors typically allocate 130% of starting capital to long positions and gain 30% from shorting stocks.
*   This strategy mimics indices like the S&P 500 to optimize stock selection.
*   Shorting stocks involves significant risks, including potential unlimited losses.
*   While often providing lower volatility, 130-30 funds might not surpass major indexes in total return.

## How the 130-30 Strategy Works

To engage in a 130-30 strategy, an investment manager might rank the stocks used in the S&P 500 from best to worse on expected return, as signaled by past performance. A manager will use a number of data sources and rules for ranking individual stocks. Typically, stocks are ranked according to some set selection criteria (for example, total returns, risk-adjusted performance, or relative strength) over a designated look-back period of six months or one year. The stocks are then ranked best to worst.

From the [best ranking stocks](https://www.investopedia.com/best-performing-s-and-p-500-stocks-8720206), the manager would invest 100% of the portfolio's value and short sell the bottom ranking stocks, up to 30% of the portfolio's value. The cash earned from the [short sales](https://www.investopedia.com/terms/s/shortsale.asp) would be reinvested into top-ranking stocks, allowing for greater exposure to the higher-ranking stocks.

## The Role of Shorting Stocks in the 130-30 Strategy

The 130-30 strategy incorporates short sales as a significant part of its activity. Shorting a stock entails borrowing securities from another party, most often a broker, and agreeing to pay an interest rate as a fee. A negative position is subsequently recorded in the investor’s account. The investor then sells the newly acquired securities on the [open market](https://www.investopedia.com/terms/o/open-market.asp) at the current price and receives the cash for the trade. The investor waits for the securities to depreciate and then re-purchases them at a lower price. At this point, the investor returns the purchased securities to the broker. In a reverse activity from first buying and then selling securities, shorting still allows the investor to profit.

Short selling is much riskier than investing in long positions in securities; thus, in a 130-30 investment strategy, a manager will put more emphasis on long positions than short positions. Short-selling puts an investor in a position of unlimited risk and a capped reward. For example, if an investor shorts a stock trading at $30, the most they can gain is $30 (minus fees), while the most they can lose is infinite since the stock can technically increase in price forever.

Hedge funds and mutual fund firms have begun offering investment vehicles in the way of private equity funds, mutual funds, or even exchange-traded funds that follow variations of the 130-30 strategy. In general, these instruments have lower volatility than benchmark indexes but often fail to achieve greater total returns.

## The Bottom Line

The 130-30 strategy puts financial leverage to work by shorting underperforming stocks and reinvesting the capital received into higher-performing stocks. The strategy's goal is to achieve efficient capital allocation while addressing risk through a balance of long and short positions. Since stock selection is important, users of the strategy often adopt a methodology that's similar to that used for tracking indexes like the S&P 500. While the 130-30 strategy can limit drawdowns and provide better risk-adjusted returns, it may not consistently outperform the total returns provided by major market averages. Certain investments, such as hedge funds and mutual funds, implement variations of the 130-30 strategy, and typically offer lower volatility but varied performance outcomes.

> **Article Sources**
>
> 1.  Armfelt, C. A. R. L., & Somos, D. A. N. I. E. L. (2008). _Performance, Benefits and Risks of Active-Extension Strategies_. Working Paper available at Stockholm School of Economics