130/30 funds were born out of the relentless pursuit of investment returns above and beyond the benchmark, otherwise known as “alpha”. In the institutional marketplace, where asset managers face intense competition to snag big-ticket clients such as pensions and endowments, beating the benchmark has become the holy grail of investment performance.

However, in reality, the majority of long-only investment managers—those who aim to “buy low and sell high”—have historically been unable to consistently generate alpha, especially after fees.

An article1 in the Journal of Portfolio Management attempted to mathematically show that the long-only constraint is one of the chief reasons for this underperformance. The authors argued that portfolio managers who are able to fully express both positive and negative views on stocks would have a better chance of capturing ever-elusive alpha.

That’s where 130/30 funds come in. They allow portfolio managers to take long positions in stocks they believe are undervalued and short positions in stocks they believe are overvalued. This strategy adds a new dimension to the portfolio manager’s alpha-generating arsenal: the ability to “sell high and buy low,” as it were.

The concept is clearly catching on. 130/30 funds were a hot topic at an investment conference we attended in New York last fall, with some estimating they could amass $1 trillion in assets over the next five years. As 130/30 funds begin to appear on the Canadian retail shelf, it’s a subject we should all become familiar with.

How they work
A 130/30 fund invests 100% of its initial capital in long positions. The portfolio manager augments these long positions with short positions equal to 30% of the fund’s value. Then, the proceeds of those short positions are reinvested in additional long positions. When the dust clears, you end up with a portfolio that’s 130% long and 30% short—thus the name 130/30.

This strategy could be considered “hedge fund lite.” Except where hedge funds generally aim to produce positive returns in all market conditions, 130/30 fund managers only concern themselves with beating the index, be it up or down.

The allure of 130/30 funds is that managers have virtually twice as many opportunities. If they love a stock, they can buy it and make money. If they hate a stock, they can sell it and make money. But, as usual, the prospect of higher returns comes with the potential for higher risk. After all, managers have twice as many opportunities to make a mistake.

Our view
130/30 is a term you will likely hear a lot in the coming months. The challenge for marketers will be to help investors and advisors grasp a strategy that’s considerably more complicated than your garden variety mutual fund. The challenge for 130/30 portfolio managers will be to prove that the strategy can indeed generate alpha. //