Although market neutral funds have many similarities to traditional funds, there are important differences. Unlike traditional money managers, market neutral fund managers have the ability to short stocks. This advantage arms market neutral money managers with the potential to achieve positive returns regardless of whether the broader market is rising or declining. The ability to short stocks alone does not turn a traditional manager into a market neutral manager. A true market neutral fund should involve a skill-based strategy that removes market risk. In a basic market neutral portfolio structure, $100 coming into the fund is invested in the manner outlined as follows: $100 stock bought long ($100) stock sold short $100 money market
The strategy involves balanced long & short positions in equity markets in an attempt to insulate the portfolio from overall market risk. The ability to short securities allows the manager to benefit from falling stock prices and to hedge away the risk of stocks held long. A true market neutral portfolio will have beta (market risk) equal to zero ( as a result of netting out the long portfolio beta and the short portfolio beta), dollar neutrality, along with additional risk controls including: - no large net economic sector exposures (sector neutral)
- no large net industry sector exposures (industry neutral)
- no large net investment style exposures (style neutral)
- no large net market capitalization exposures (market capitalization neutral)
If structured properly, market neutral equity removes market risk. It is important to note, however, that the market risk is then replaced with manager risk and his/her ability to pick stocks. The manager must possess the ability to pick stocks in a manner that on average in an up market his longs go up more than his shorts, and in a down market his shorts fall further than his longs. If he can do this with some consistency over the long term, he can add value in up and down markets and produce relatively smooth, risk adjusted returns. Where do the returns come from in a portfolio structured in this manner? For any hedge fund strategy, once one understands where the returns come from, it becomes clear what the inherent risks of the strategy are. Below is a depiction of where a market neutral portfolio returns come from: Fund Return = (Return on Long Stocks + Return on Shorted Stocks) + T-Bill Rate As this equation suggests, the key to adding value is to buy stocks which go up more (or down less) than the stocks sold short. When properly executed, the fund return is almost fully insulated from stock market moves. While market risk has effectively been removed from the portfolio, it has been replaced by manager specific risk, or the ability to pick stocks. Here’s how it works: A manager takes a long position in a retail company, the data of which suggests that the long term prospects are very good. He then balances this position by taking a short position in a similar retail company, the data of which suggests it is not positioned as strongly. Let’s look at what happens if there is a six percent correction in that sector. As often occurs, the correction affects all companies in a sector, so we will assume both the long and short positions are affected. Ideally, the shorted stock would over-correct – it may go down 8%. The stock held “long” did exactly what the market did – it declined 6%. The net gain would be 8% from the “shorted company”, less 6% from the company held “long”, for a total of 2%. In this example, the individual positions actually made money in a down market. Taking a look from the portfolio level, here is an example of how the overall portfolio can react in different market environments: S&P 500 goes up 10%: - Average return on stocks held long = 13%
- Average return on stocks sold short = 7%
- Average T-bill rate over period = 4%
- Long-short portfolio return = (13% - 7%) + 4% = 10%
S&P 500 goes down 10%: - Average return on stocks held long = -7%
- Average return on stocks sold short = -13%
- Average T-bill rate over period = 4%
- Long-short portfolio return = (-7% + 13%) + 4% = 10%
The portfolio is “market neutral” since general market moves do not affect its return. The portfolio has an opportunity for positive returns regardless of market direction as long as the manager possesses the ability to add value through his stock picking. Because market neutral portfolio returns are uncorrelated with stock and bond market returns, they provide a powerful diversification tool when added to a traditional portfolio made up of stocks, bonds and cash. |
