How Does the Market Neutral Fund Strategy Work?
A market neutral fund that invests in the public equities market identifies “pairs” of stocks with comparable risk characteristics but are perceived to be mispriced relative to each other.
The portfolio of a market neutral fund is composed of long and short positions in different securities to achieve a state of net-zero market exposure.
The term “net-zero market exposure” describes fund returns that are unaffected by the directional movements of the broader market.
The relative performance of the selected securities determines the fund returns over the long run, as opposed to the broad markets (e.g. equity, bond, credit).
The specific selection of securities to pair long and short positions can be decided based on either fundamental or quantitative analysis.
- Undervalued Securities → Long Positions
- Overvalued Securities → Short Positions
The pair strategy is performed to balance the two long-short positions, so the dollar amounts of the long and short positions are set to be near equivalent, resulting in a net market exposure of zero.
If the undervalued stock increases in value, while the overvalued stock declines in value, the fund profits from both the long and short positions — or in the worst-case scenario, incurs a loss on both positions.
Learn More → Hedge Fund Primer
Why Invest in Market Neutral Funds?
So, what are the benefits of investing in a market neutral fund?
- Portfolio Diversification → Market neutral funds are designed to generate returns uncorrelated with the broader market, so the investment firm benefits from portfolio diversification.
- Less Market Risk (Lower Volatility) → Since market neutral funds strive to achieve a net market exposure of zero, the returns tend to exhibit less volatility in comparison to other investment strategies (e.g. long-only), which can cause market-neutral funds to be an attractive option to risk-averse investors.
- Market-Independent Returns (Uncorrelated) → The act of taking both long and short positions creates the potential for positive returns, regardless of the overall market conditions (i.e. bull or bear market).
While in theory, the market neutral fund strategy can neutralize market risk, the strategy still bears other types of risks inherent to the speculative nature of equities investing.
In particular, the short-selling component of the strategy carries substantial risk, especially if the fund relies on leverage to increase the potential upside in returns.
AQR Equity Market Neutral Fund Performance (Source: AQR Funds Annual Report)
What is an Example of Market Neutral Strategy?
A common example of a market-neutral fund strategy is “pair trading”.
For instance, suppose a market neutral hedge fund pairs investments in Alphabet (NASDAQ: GOOGL) and Microsoft (NASDAQ: MSFT).
The hedge fund manager takes paired long-short positions under the belief that the shares of Alphabet are currently undervalued, whereas the shares in Microsoft are overvalued.
- “Long” Position → Alphabet (GOOGL)
- “Short” Position → Microsoft (MSFT)
Based on the beta of each security, the amount of capital placed into the offsetting positions, i.e. the portfolio weights – will be structured to achieve a portfolio beta near zero.
The performance of Alphabet and Microsoft are exposed to similar risks and historically, their past stock price movements relative to the broader market (S&P) have exhibited a strong correlation.
However, their respective share prices do not reflect their intrinsic value from the perspective of the hedge fund.
The relatively even split between long and short positions in the investment portfolio yields a net market exposure near zero (i.e. portfolio beta), which reduces the fund’s exposure to market fluctuations.
The three potential outcomes are as follows.
- Outcome #1 → If Alphabet’s share price rises while Microsoft falls, the predicted outcome of the fund has come to fruition and the fund reaps the rewards from the correct predictions.
- Outcome #2 → If Alphabet’s share price declines while Microsoft rises, the fund will incur losses from speculating incorrectly on the price movements.
- Outcome #3 → If Alphabet’s share price increases, but Microsoft also rises – or if the share price of both securities declines – the incorrect bet is offset by the correct bet on the other paired position.
The returns of the market neutral fund are largely predicated on the fundamental analysis performed and the selection of securities by the portfolio manager, as well as the unpredictable variables that the hedging strategy is meant to mitigate.
In conclusion, as our quick market neutral strategy example illustrates, the relative performance of the paired securities – rather than the direction of the broader market – is the primary factor that determines the returns achieved by the fund.
