Goldman Sachs, Barclays and State Street already have billions of assets managed in 130/30 strategies and some tout this approach as the wave of the future for investing. Although this strategy is often used by hedge funds and applied to equities, you can also build your own 130/30 portfolio using ETFs.

Investors are attracted to this strategy driven by an urge to beat index returns but also a desire to not be too aggressively leveraged. With a 130/30 strategy you use an index fund for beta exposure and exposure to the market. At the same time you sell short those funds or securities that you believe will underperform.

These strategies go by several names, such as long plus or partial long-short, and essentially offer investors both a beta component, market return, and a long/short, or alpha component. Positive alpha is extremely desirable since it is the holy grail of investing and is the extra return an investor makes by taking on additional risk rather than accepting the market return.

The Future?
A portfolio managed according to a 130/30 strategy is exactly that -- it seeks 130% exposure to a market, with a 30% short position so that the net result is a 100% long exposure to the market. The first step is to invest 100% of assets in a security expected to rise in value and, at the same time, sell 30% of the holdings short. Then take the cash generated from the short sale and reinvest that in long positions.

This financial wizardry might enhance returns for two reasons. First, you can make money on your long positions, as well as your short positions. In addition, you can put even more money to work in your top investment selections from the short sales

Variations on a Theme
Investors who are more risk averse can pare exposure down to a 120/20 strategy. Meanwhile, those investors who seek higher returns, and who are comfortable with the attendant risk, could ratchet up their portfolios to a 150/50 position.

130/30 Example
Let's say your goal is to outperform the S&P 500 Index and you have $1,000 to invest. You can use a large-cap fund such as the iShares S&P 500 Index Fund (NYSE:IVV) for your long positions and one of the various sector funds such as the Technology SPDR (AMEX:XLK) for the short positions. These are the steps:

  • Buy $1,000 of a large-cap fund such as SPY or IVV.
  • Sell short $300 of an industry or sector ETF that you believe will underperform the market, i.e. XLK.
  • Buy $300 more of SPY or IVV with the proceeds of the short sales.

Sector and Industry ETFs
There are now numerous choices among the Sector SPDRs, iShares and ProShares funds for investors to select a sector ETF to use in a 130/30 or similar strategy. In addition, there are also close to 100 different industry ETFs for those who want to narrow the market down even further. Some of these funds are limited to 20 or so funds, making them particularly focused, and might be especially suited for investor who wants to use ETFs for this strategy.

Variations of the Strategy
Most 130/30 strategies have been developed using large caps as the foundation. That's likely to change since these types of strategies could be used with a style as well as capitalization focus. In addition, it's easy to see that this type of strategy could be managed at the country, region, or global level using ETFs.

The biggest risk of a 130/30 strategy is most likely going to be market risk, since you have full market exposure. Volatility in the market is going to impact your investment one way or the other.

The primary assumption for a successful 130/30 strategy is the ability to pick funds which will be winners and losers. Since that is not always possible, picking the wrong fund to be long or short can result in a reduction of the returns you expect.

This strategy can also be risky because leverage is embedded in long/short structures. Any investment strategy using leverage can have returns more volatile than those in unlevered portfolios.

This is clearly not a strategy for investors who don't have a really good handle on how the market and specific funds are likely to perform going forward. At the same time, ETFs seem uniquely suited to this investment strategy, since they now slice the market into jumbo- and mini-morsel-sized chunks and they can be shorted.

With more investors focused on alpha it's likely that long-only constraints will be loosened and short-selling will be incorporated into their investing repertoire. A 130/30 strategy is one way to take advantage of that newfound freedom. After all, why not seek value from both positive investment options and negative ones? The problem is that these strategies are new, so the jury is out on what to expect as far as risk and return. Time will tell whether this is the future of investing or another investment fad.

Contributor Zoe Van Schyndel lives in Miami and enjoys the sunshine and variety of the Magic City. She owns shares of SPY but does not own any of the other funds or securities mentioned in this article. The Motley Fool has a disclosure policy.