A market-neutral strategy, in general, seeks to generate investment returns that are unaffected by market conditions.
The portfolio manager makes both short and long investments to offset the impact of equity market fluctuations. In aggregate, the dollar value of the quick assets, which pay off if the value of a stock falls, will be roughly equal to the dollar value of the more traditional long investments, which appreciate if the stock price rises. If markets fall, the shorts will hedge against losses in the long positions.
Taking short positions allows the portfolio manager to express negative and positive convictions about particular stocks. A long-only manager can express an unfavorable opinion only by avoiding a store, but this has a relatively small impact on performance. On the other hand, a market-neutral manager can seek to affect portfolio performance by actively shorting stocks materially. An examination of the Russell 1000 Index over the last 37 years demonstrates this point. A market-neutral strategy is similar to a long/short plan in many ways. Both primarily invest in publicly traded stocks, with the occasional use of derivatives, exchange-traded funds, and other instruments to manage risks, express conviction, or reduce costs. However, there is a critical distinction; long/short strategies typically share in the swings of the equity market. This is because managers can and often do have unequal sums invested in their long and short positions.
Market-Neutral Strategies Perform Well
Market-neutral strategies seek to profit from variations in stock returns. Managers attempt to capture the spread between the strongest and weakest stocks by shorting stocks they consider unattractive and taking long positions in attractive stocks. It works best when there is a significant difference in performance between the best and worst-performing stocks. When stocks move in lockstep, as they do at the extremes of both “irrational exuberance” and macroeconomic angst, it doesn’t matter much whether one owns the best or worst stocks. The tide has engulfed all of the boats.
Periods of high stock correlation are typically associated with extreme risk-seeking or risk aversion. In these times, a stock’s perceived riskiness (or lack thereof) tends to determine returns rather than its fundamental attractiveness. Over time, the index showed little correlation to the movements of stocks, bonds, real estate, commodities, and other alternative strategies. These low correlations have proven to be an effective diversifier.
Inflation and Return Dispersion
Rising short-term interest rates have historically been beneficial to market-neutral strategies. A short sale occurs when an investor pays a fee to borrow a stock he believes will fall in value. He sells the stock at the current high price. He deposits the proceeds in a savings account, earning interest at the federal funds rate. If his bet is successful, the stock falls in value; therefore it would allow for the short seller to purchase it at a lower price and return it to the lender.
Key risk factors include manager skill and spikes in correlation with stock returns, limiting the reward for superior stock selection. This dynamic was most visible from the middle of 2007 to late 2009, when extreme risk aversion drove correlations among stock returns to new highs.
Investors who expect short-term interest rates to rise and those looking to stabilize and diversify their portfolios with investments that do not typically move in tandem with most traditional asset classes will benefit from market-neutral strategies. Investors who are unsure about the market’s direction or already highly vulnerable to swings in the capital markets may fall into this category. According to our findings, a typical investor with a target allocation of 60% equities and 40% bonds could benefit from allocating 10% to 20% to a market-neutral strategy. The advantage stems primarily from lower volatility in the overall portfolio with comparable returns.
Manager skill is a critical variable in a market-neutral strategy; hence, we analyzed to recommend allocations to the hypothetical scenario based on manager skill. It is essential to remember that the starting assumptions about expected returns, volatility, and correlations of stocks, bonds, and the market-neutral strategy are extremely sensitive to an optimal asset mix.
Risks to Consider
Market-neutral investments, like all investment strategies, may lose value. They share some or all of the risks associated with the various methods and asset classes they employ.
There is no guarantee that a manager’s techniques and portfolio components will work as intended at the most basic level. Market-neutral strategies may invest in derivatives, which can be riskier and more volatile than traditional investments, especially in down markets. They may also invest in less liquid securities, which are more challenging to buy and sell at will. They use leverage tactics, such as short sales to magnify gains and losses.
Some strategies may invest globally, potentially exposing investors to currency, political, and economic volatility. Furthermore, the costs of a market-neutral plan may pose a downside risk. Costs associated with investment methods such as short selling or exchange-traded funds and transaction costs generated by portfolio turnover can detract from performance. Furthermore, some short-term gains may have adverse tax consequences for some clients.
An All-Weather Option
Market-neutral strategies could be a valuable addition to a traditional stock-and-bond portfolio. A well-designed market-neutral strategy should provide excess return regardless of equity market swings. As a result, it should help to protect investors from market crises and periods of unsettling volatility. A market-neutral strategy may also help mitigate the effects of rising short-term interest rates and inflation, as it should perform well in those conditions. These benefits may be especially appealing to investors at this time, as markets remain volatile and interest rates remain near historic lows.
Choosing a skilled market-neutral manager is critical because returns should not be driven by the market’s overall direction but rather by the manager’s ability.
Indeed, the ability of the manager is a significant source of risk. A poorly designed or executed strategy may fail to provide the desired insulation and amplify market swings. Manager evaluation can be complex due to the wide range of tactics and the relative novelty of market-neutral products. As a result, advisors must delve deeply into the specifics of each product’s structure and backup plans.
Many investors may benefit from a market-neutral allocation now that they understand this.
A market-neutral strategy may be a valuable addition to a traditional stock-and-bond portfolio. Market-neutral strategies may help defuse market risk and volatility by utilizing a finely calibrated combination of long and short stock investments, improving overall returns.