Investment Product Review

 

In this series we examine investment products and strategies, from the mundane to the highly complex, explaining how they work and why we do or do not use these particular products or strategies in our portfolios.

Alternatives: Market Neutral Strategies – Part 3

The previous post on alternative investment styles discussed directional equity investment strategies, meaning funds that attempt to provide excess returns both through stock selection and through the use of short selling.  This Investment Product Review will highlight a specific type of long/short strategy: market neutral investing.  This style of investing focuses on producing “pure alpha” with little-to-no beta exposure (where beta is the amount of returns that can be attributed to market risk, and alpha is return in excess of market risk exposure).

Dow Jones Industrials Continues To Slide Downward

When a portfolio strategy is referred to as “market neutral,” it implies that the net beta of the portfolio is approximately zero1.  For net beta to be zero, the expected portfolio returns must be uncorrelated to the returns of the market index on which it is based.  For example, a market neutral fund based on the S&P 500 Index should have a zero correlation with that index.  This is achieved by purchasing and short selling stocks in a manner that causes the total beta of the portfolio to net to zero.  This strategy should substantially reduce the volatility of the portfolio by neutralizing general market movement.  Theoretically, removing beta exposure from a portfolio should result in all returns being a function of the alpha generated through individual security selection. The removal of effect of beta is what makes market neutral strategies a play for pure alpha.  If the portfolio has no net exposure to markets, in order to generate positive return the portfolio manager must purchase stocks that increase more (or decrease less) in price than the corresponding stocks that have been sold short.

Because market neutral strategies are intended to be immune to market movement and generate returns only through superior security selection, they are generally considered to be low-risk but also low-return strategies.  With this in mind, fund managers often employ leverage in their market neutral portfolios to enhance the investment returns.  While this idea sounds reasonable in theory, the results can be less than optimal in practice.  Funds that are designed to be market neutral based on past return data are not guaranteed to remain that way in the future.  One common side effect of a turbulent market is that correlations between asset classes can change, leading a portfolio to have a different level of market exposure than it might have previously appeared to have.  An example of this took place in the late 1990’s. A common strategy was to go long on value stocks (or stocks with low price/earnings ratios) and to go short on growth stocks (stocks with high P/E ratios).  While the historical beta of the stocks in these portfolios may have netted to zero, this relationship did not continue to hold during the tech boom, when technology stocks (which are nearly always growth stocks) far outpaced value stocks.  Funds who engaged in the above “market neutral” strategy tended to have strongly negative returns, and those losses were exacerbated by any leverage used.

Given the nature of the strategy, in order for this style of investing to succeed, the fund manager must be able to add value through security selection.  However, academic research has shown time and time again that fund managers are not able to consistently add value through stock picking, and in fact do no better than would be expected by random chance.  This means that market neutral strategies have a high likelihood of failing before they even begin investing.  If a fund manager is not able to consistently choose securities that outperform, and the portfolio itself holds no net exposure to broad market movement, then the expected long-term returns of this strategy should be negligible.  Any positive returns must either come from luck (in asset selection) or unintended market exposure.  In fact, the annualized return over the previous five years of an index of market neutral hedge funds is -0.05%2; exactly what would be expected in an efficient market.  Over the same period, the S&P 500 index has returned 7.01%3 per year.

Market neutral funds are often sold as an alpha generating alternative that have the additional benefit of low volatility and minimal correlation with other equity strategies.  However, they generally prove to be an expensive strategy with low expected returns and the possibility of large hidden risks.  For investors who want safe assets that tend to be uncorrelated with equity markets, investment grade fixed income is likely a far safer and more cost-effective method of gaining this exposure.

Previous posts in this series:

References
1. In other words, the weighted sum of the betas of the long and short assets in the portfolio equal zero.
2. Source: Hedge Fund Research Inc. (HFRI) Equity Market Neutral Index
3. S&P 500 data provided by Dimensional Fund Advisors.

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About Erik Lehr

Erik graduated from the University of Oregon with a Bachelor of Economics and Mathematics degree. His background includes master’s degree in economics and a Master of Science in Computational Finance and Risk Management from the University of Washington. Erik also holds the Chartered Alternative Investment Analyst (CAIA®) designation.

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