For investors, there are two key benefits to adding market neutral equity strategy to an already existing, well-diversified investment portfolio.1. On a stand alone basis, market neutral equity strategy can offer a risk-return tradeoff that is superior to long-only equity, bonds and other hedge fund strategies. A client begins with an existing portfolio of traditional equity funds. She has a choice between adding various amounts of an additional traditional equity fund, or various amounts of an equity market neutral fund. Assuming no risk /return advantages between the traditional equity fund and the equity market neutral fund, each has a return potential of 8% per annum and a risk profile of 16% per annum. However, the traditional equity portfolio is 90% correlated with the existing portfolio while the equity market neutral portfolio has a 0% correlation with the initial portfolio. Clearly, there is no benefit to adding an asset class (the blue diamonds on the graph) which is 90% correlated to the existing portfolio. The green triangles represent the addition of various percentages of an equity market neutral fund. The drop in the expected risk of the new portfolio is profound. The equity market neutral’s 0% correlation with the initial portfolio means that it has the potential to smooth out the return stream of the new portfolio.
Hedge fund index data suggests that the average market neutral equity manager in the World has: - Added substantial value through stock selection;
- Produced returns greater than or equal to equity;
- Produced these returns with substantially less volatility risk than equity;
- And, produced these returns while being approximately uncorrelated with the equity indexes.
2 - When combined with a portfolio of long-only equity, bonds and other hedge funds, market neutral equity can increase overall returns while substantially lowering overall risk (concept of asset allocation). This is due to the fact that market neutral equity portfolio returns are virtually uncorrelated with stock and bond market returns. Therefore, the addition of market neutral equity can have a profound risk reduction effect on an overall portfolio through increased diversification. This is even more important now as international market correlations have increased (meaning less benefit from international equity diversification), and stock and bond market correlations have increased (meaning less benefit from stock and bond diversification). This example assumes that the equity market neutral fund, with its ability to short securities and therefore benefit from falls in the overall stock market, has a higher return potential than a traditional equity fund. Again the blue diamonds represent the inability of a 90% correlated fund to add value to an existing traditional equity portfolio. The green triangles illustrate the profound risk reduction and enhanced return potential of adding a 0% correlated equity market neutral fund. |
