What Is the 130-30 Strategy?

The 130-30 strategy, often called a long/short equity strategy, refers to an investing methodology used by institutional investors. A 130-30 designation implies using a ratio of 130% of starting capital allocated to long positions and accomplishing this by taking in 30% of the starting capital from shorting stocks.

The strategy is employed in a fund for capital efficiency. It uses financial leverage by shorting poor-performing stocks and, with the cash received by shorting those stocks, purchasing shares that are expected to have high returns. Often, investors will mimic an index such as the S&P 500 when choosing stocks for this strategy.

Understanding the 130-30 Strategy

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, 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 would be reinvested into top-ranking stocks, allowing for greater exposure to the higher-ranking stocks.

130-30 Strategy and Shorting Stocks

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 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.

What Is the Adjusted Closing Price?

The adjusted closing price amends a stock’s closing price to reflect that stock’s value after accounting for any corporate actions. It is often used when examining historical returns or doing a detailed analysis of past performance.

Understanding the Adjusted Closing Price

Stock values are stated in terms of the closing price and the adjusted closing price. The closing price is the raw price, which is just the cash value of the last transacted price before the market closes. The adjusted closing price factors in anything that might affect the stock price after the market closes.

A stock’s price is typically affected by supply and demand of market participants. However, some corporate actions, such as stock splits, dividends, and rights offerings, affect a stock’s price. Adjustments allow investors to obtain an accurate record of the stock’s performance. Investors should understand how corporate actions are accounted for in a stock’s adjusted closing price. It is especially useful when examining historical returns because it gives analysts an accurate representation of the firm’s equity value.

Types of Adjustments

Adjusting Prices for Stock Splits

A stock split is a corporate action intended to make the firm’s shares more affordable for average investors. A stock split does not change a company’s total market capitalization, but it does affect the company’s stock price.

For example, a company’s board of directors may decide to split the company’s stock 3-for-1. Therefore, the company’s shares outstanding increase by a multiple of three, while its share price is divided by three. Suppose a stock closed at $300 the day before its stock split. In this case, the closing price is adjusted to $100 ($300 divided by 3) per share to maintain a consistent standard of comparison. Similarly, all other previous closing prices for that company would be divided by three to obtain the adjusted closing prices.

Adjusting for Dividends

Common distributions that affect a stock’s price include cash dividends and stock dividends. The difference between cash dividends and stock dividends is that shareholders are entitled to a predetermined price per share and additional shares, respectively.

For example, assume a company declared a $1 cash dividend and was trading at $51 per share before then. All other things being equal, the stock price would fall to $50 because that $1 per share is no longer part of the company’s assets. However, the dividends are still part of the investor’s returns. By subtracting dividends from previous stock prices, we obtain the adjusted closing prices and a better picture of returns.

Adjusting for Rights Offerings

A stock’s adjusted closing price also reflects rights offerings that may occur. A rights offering is an issue of rights given to existing shareholders, which entitles the shareholders to subscribe to the rights issue in proportion to their shares. That will lower the value of existing shares because supply increases have a dilutive effect on the existing shares.

For example, assume a company declares a rights offering, in which existing shareholders are entitled to one additional share for every two shares owned. Assume the stock is trading at $50, and existing shareholders can purchase additional shares at a subscription price of $45. After the rights offering, the adjusted closing price is calculated based on the adjusting factor and the closing price.

Benefits of the Adjusted Closing Price

The main advantage of adjusted closing prices is that they make it easier to evaluate stock performance. Firstly, the adjusted closing price helps investors understand how much they would have made by investing in a given asset. Most obviously, a 2-for-1 stock split does not cause investors to lose half their money. Since successful stocks often split repeatedly, graphs of their performance would be hard to interpret without adjusted closing prices.

Secondly, the adjusted closing price allows investors to compare the performance of two or more assets. Aside from the clear issues with stock splits, failing to account for dividends tends to understate the profitability of value stocks and dividend growth stocks. Using the adjusted closing price is also essential when comparing the returns of different asset classes over the long term. For example, the prices of high-yield bonds tend to fall in the long run. That does not mean these bonds are necessarily poor investments. Their high yields offset the losses and more, which can be seen by looking at the adjusted closing prices of high-yield bond funds.

Criticism of the Adjusted Closing Price

The nominal closing price of a stock or other asset can convey useful information. This information is destroyed by converting that price into an adjusted closing price. In actual practice, many speculators place buy and sell orders at certain prices, such as $100. As a result, a sort of tug of war can take place between bulls and bears at these key prices. If the bulls win, a breakout may occur and send the asset price soaring. Similarly, a win for the bears can lead to a breakdown and further losses. The adjusted close stock price obscures these events.

By looking at the actual closing price at the time, investors can get a better idea of what was going on and understand contemporary accounts. If investors look at historical records, they will find many examples of tremendous public interest in nominal levels. Perhaps the most famous is the role that Dow 1,000 played in the 1966 to 1982 secular bear market. During that period, the Dow Jones Industrial Average (DJIA) repeatedly hit 1,000, only to fall back shortly after that. The breakout finally took place in 1982, and the Dow never dropped below 1,000 again. This phenomenon is covered up somewhat by adding dividends to obtain the adjusted closing prices.

In general, adjusted closing prices are less useful for more speculative stocks. Jesse Livermore provided an excellent account of the impact of key nominal prices, such as $100 and $300, on Anaconda Copper in the early 20th century. In the early 21st century, similar patterns occurred with Netflix (NFLX) and Tesla (TSLA). William J. O’Neil gave examples where stock splits, far from being irrelevant, marked the beginnings of real declines in the stock price. While arguably irrational, the impact of nominal prices on stocks could be an example of a self-fulfilling prophecy.

What Is an Anomaly?

In economics and finance, an anomaly is when the actual result under a given set of assumptions is different from the expected result predicted by a model. An anomaly provides evidence that a given assumption or model does not hold up in practice. The model can either be a relatively new or older model.

Understanding Anomalies

In finance, two common types of anomalies are market anomalies and pricing anomalies. Market anomalies are distortions in returns that contradict the efficient market hypothesis (EMH). Pricing anomalies are when something—for example, a stock—is priced differently than how a model predicts it will be priced.

Common market anomalies include the small-cap effect and the January effect. The small-cap effect refers to the small company effect, where smaller companies tend to outperform larger ones over time. The January effect refers to the tendency of stocks to return much more in the month of January than in others.

Anomalies also often occur with respect to asset pricing models, in particular, the capital asset pricing model (CAPM). Although the CAPM was derived by using innovative assumptions and theories, it often does a poor job of predicting stock returns. The numerous market anomalies that were observed after the formation of the CAPM helped form the basis for those wishing to disprove the model. Although the model may not hold up in empirical and practical tests, it still does hold some utility.

Anomalies tend to be few and far between. In fact, once anomalies become publicly known, they tend to quickly disappear as arbitragers seek out and eliminate any such opportunity from occurring again.

Types of Market Anomalies

In financial markets, any opportunity to earn excess profits undermines the assumptions of market efficiency, which states that prices already reflect all relevant information and so cannot be arbitraged.

January Effect

The January effect is a rather well-known anomaly. According to the January effect, stocks that underperformed in the fourth quarter of the prior year tend to outperform the markets in January. The reason for the January effect is so logical that it is almost hard to call it an anomaly. Investors will often look to jettison underperforming stocks late in the year so that they can use their losses to offset capital gains taxes (or to take the small deduction that the IRS allows if there is a net capital loss for the year). Many people call this event tax-loss harvesting.

As selling pressure is sometimes independent of the company’s actual fundamentals or valuation, this “tax selling” can push these stocks to levels where they become attractive to buyers in January.

Likewise, investors will often avoid buying underperforming stocks in the fourth quarter and wait until January to avoid getting caught up in the tax-loss selling. As a result, there is excess selling pressure before January and excess buying pressure after Jan. 1, leading to this effect.

September Effect

The September effect refers to historically weak stock market returns for the month of September. There is a statistical case for the September effect depending on the period analyzed, but much of the theory is anecdotal. It is generally believed that investors return from summer vacation in September ready to lock in gains as well as tax losses before the end of the year.

There is also a belief that individual investors liquidate stocks going into September to offset schooling costs for children. As with many other calendar effects, the September effect is considered a historical quirk in the data rather than an effect with any causal relationship. 

Days of the Week Anomalies

Efficient market supporters hate the “Days of the Week” anomaly because it not only appears to be true, but it also makes no sense. Research has shown that stocks tend to move more on Fridays than Mondays and that there is a bias toward positive market performance on Fridays. It is not a huge discrepancy, but it is a persistent one.

The Monday effect is a theory which states that returns on the stock market on Mondays will follow the prevailing trend from the previous Friday. Therefore, if the market was up on Friday, it should continue through the weekend and, come Monday, resume its rise. The Monday effect is also known as the “weekend effect.”

On a fundamental level, there is no particular reason that this should be true. Some psychological factors could be at work. Perhaps an end-of-week optimism permeates the market as traders and investors look forward to the weekend. Alternatively, perhaps the weekend gives investors a chance to catch up on their reading, stew and fret about the market, and develop pessimism going into Monday.

Superstitious Indicators

Aside from calendar anomalies, there are some non-market signals that some people believe will accurately indicate the direction of the market. Here is a short list of superstitious market indicators:

• The Super Bowl Indicator: When a team from the old American Football League wins the game, the market will close lower for the year. When an old National Football League team wins, the market will end the year higher. Silly as it may seem, the Super Bowl indicator was correct almost three-quarters of the time over a 53-year period ending in 2021. However, the indicator has one limitation: It contains no allowance for an expansion-team victory!
• The Hemline Indicator: The market rises and falls with the length of skirts. Sometimes this indicator is referred to as the “bare knees, bull market” theory. To its merit, the hemline indicator was accurate in 1987, when designers switched from miniskirts to floor-length skirts just before the market crashed. A similar change also took place in 1929, but many argue as to which came first, the crash or the hemline shifts.
• The Aspirin Indicator: Stock prices and aspirin production are inversely related. This indicator suggests that when the market is rising, fewer people need aspirin to heal market-induced headaches. Lower aspirin sales should indicate a rising market.

What Is an Arbitrageur?

An arbitrageur is a type of investor who attempts to profit from market inefficiencies. These inefficiencies can relate to any aspect of the markets, whether it is price, dividends, or regulation. The most common form of arbitrage is price.

Arbitrageurs exploit price inefficiencies by making simultaneous trades that offset each other to capture risk-free profits. An arbitrageur would, for example, seek out price discrepancies between stocks listed on more than one exchange by buying the undervalued shares on one exchange while short selling the same number of overvalued shares on another exchange, thus capturing risk-free profits as the prices on the two exchanges converge.

In some instances, they also seek to profit by arbitraging private information into profits. For example, a takeover arbitrageur may use information about an impending takeover to buy up a company’s stock and profit from the subsequent price appreciation.

Understanding an Arbitrageur

Arbitrageurs are typically very experienced investors since arbitrage opportunities are difficult to find and require relatively fast trading. They also need to be detail-oriented and comfortable with risk. This is because most arbitrage plays involve a significant amount of risk. They are also bets with regards to the future direction of markets.

Arbitrageurs play an important role in the operation of capital markets, as their efforts in exploiting price inefficiencies keep prices more accurate than they otherwise would be.

Examples of Arbitrageur Plays

As a simple example of what an arbitrageur would do, consider the following.

The stock of Company X is trading at $20 on the New York Stock Exchange (NYSE) while, at the same moment, it is trading for the equivalent of $20.05 on the London Stock Exchange (LSE). A trader can buy the stock on the NYSE and immediately sell the same shares on the LSE, earning a total profit of 5 cents per share, less any trading costs. The trader exploits the arbitrage opportunity until the specialists on the NYSE run out of inventory of Company X’s stock, or until the specialists on the NYSE or LSE adjust their prices to wipe out the opportunity.

An example of an information arbitrageur was Ivan F. Boesky. He was considered a master arbitrageur of takeovers during the 1980s. For example, he minted profits by buying stocks of Gulf oil and Getty oil before their purchases by California Standard and Texaco respectively during that period. He is reported to have made between $50 million to $100 million in each transaction.

The rise of cryptocurrencies offered another opportunity for arbitrageurs. As the price of Bitcoin reached new records, several opportunities to exploit price discrepancies between multiple exchanges operating around the world presented themselves. For example, Bitcoin traded at a premium at cryptocurrency exchanges situated in South Korea as compared to the ones located in the United States. The difference in prices, also known as the Kimchi Premium, was mainly because of the high demand for crypto in these regions. Crypto traders profited by arbitraging the price difference between the two locations in real-time.