130/30 Mutual Fund
is a method of investing funds commonly adopted by investors from institutions. They use 130/30 to imply a starting capital ratio of 130%, assigned to long positions, to 30% starting capital for short positions.
How 130/30 Mutual Fund Works
S&P 500 Index: The S & P, which stands for Standard and Poor index, is the capital index of the topmost publicly trading companies in the United States. S&P 500 stocks are placed on a ranking scheme by an investment manager based on their previous returns. The manager may rank them from worst to best or vice versa using accumulated data on those stocks while following a ranking rule set. Managers consider things like relative strength, total returns, net profit, and risk-adjusted-performance when ranking. Usually, these values are observed over a particular amount of time, like a year or six months.
The 130/30 Mutual Fund implements this same strategy to calculate the S&P 500 Index when picking stocks. That is by ranking them from worst to best. After the ranking, the investment manager then buys the best-ranking stocks with 100% of the portfolio's value and shorts 30% of the lowest ranking. The shorted stocks are sold, and the returns are used to buy into more top-ranking stocks. This allows the investment to become more exposed to the best-ranking stocks.
Shorting a Stock: refers to the act of borrowing securities from another broker or any other third party and paying back with interest. After recording a negative position in the investors' point, the borrowed securities are sold for cash on the open market. After the sold securities depreciate, the investor repurchases them at a lower price and returns them to the broker they were borrowed from while keeping some as profit. This comes with many risks; there is always a possibility that a stock may never drop in price, and the interest yielded is capped.
Example of 130/30 Mutual Funds
The 130/30 funds improve the length of exposure to high-ranking stocks (i.e., stocks with higher returns). In the beginning, the funds purchase 100% of long positions. 30% of the lowest-performing stocks are then short, and the proceeds are used to increase another 30% long positions, making it 130%.
For example, let's say you have $1000 and you are looking to invest. You then put the $1000 in an investment fund used to buy $1000 worth of stocks which can also be referred to as 100% long positions. You then use this same fund to borrow about $300 worth of the least profitable stocks, referred to as 30% short. These stocks are then sold for a particular price. You then use the money you make from selling the borrowed 30% and buy another $300 worth of the most profitable stocks.
The means that your fund has $1300 worth of stocks or 130% long positions while shortening $300. This fund is an example of a 130/30 fund. Another name for the 130/30 funds is short-extension funds or long-short equity funds.
Significance of the 130/30 Mutual Funds
The 130/30 fund strategy gives the investment manager the luxury to handpick individual stocks that they believe will perform better. Typically investment managers can invest 100% of the investment funds into well-performing stocks. With the 130/30 fund, they have decision access to about 130% and another 30% of the mutual fund assets.
In the previous example, investment decisions were made with 160% of the portfolio's assets when the manager bought 130% worth of stocks and a short 30% of the mutual fund. The 30% market exposure is negative (because you borrowed it), and 130 market exposure was positive, making it 30% short and 130% long. This method makes the invested funds more capital efficient. The shortened stocks are doing poorly, and the money received from that buys better-performing stocks.
The main difference between 130/30 mutual funds investment and other investment forms is that if an investment manager deems particular stocks to be lousy, he can handpick and sell those stocks. It gives more opportunity and exposure to investors. But this does not mean that it is without risk. It incurs are risks associated with short selling and leveraging techniques.