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Market Neutral Investing
Questions and Answers About
Market Neutral Investing
This chapter addresses, in a user-friendly, question-and-answer format, some broad issues relating to market neutral investing in general. In particular, what is market neutral? What are its sources of return? What are its risks? How can it fit into an institutions overall investment plan? Answering the questions are: Jane Buchan, Bruce I. Jacobs, and Kenneth N. Levy.
What is market neutral investing?
Bruce Jacobs: It can be thought of as a portfolio construction technique that encourages the use of both long and short positions, where the securities are selected from a particular asset class, but the risk of the asset class itself is neutralized.
Jane Buchan: So the risk that remains is security selection risk, while the market neutral portfolio is constructed so that its returns are unaffected by the returns of the asset class itself or a given benchmark.
Ken Levy: For instance, a market neutral equity portfolio holds long stocks that are expected to appreciate in value and sells short a roughly equivalent amount of stocks that are expected to perform poorly, keeping the benchmark-relative risks of the long and short positions equal. Gains or losses on the long positions resulting from movements in the general stock market will be approximately offset by similar-size losses or gains on the short positions, leaving the spread between the returns on the long and short positions. If the securities behave as expected, with the longs outperforming the shorts, this spread will result in a positive return from security selection. Market neutral bond portfolios can be constructed in a similar fashion to be neutral to movements in underlying interest rates.
Buchan: There are also somewhat more specialized market neutral strategies, such as merger, or risk, arbitrage. In merger arbitrage, the investor buys the stocks of companies that are takeover targets and sells short the stocks of companies that are the potential buyers. The overall portfolio will be roughly immune to movements in the general market, as any changes in the values of the stocks resulting from general market movements will cancel out, long and short, while the portfolio will benefit if its constituent stocks perform as expected, with the stocks of the takeover candidates rising in price as the takeover approaches and the stocks of the potential buyers falling upon completion of the takeover.
So its a matter of buying undervalued securities and selling short overvalued securities?
Jacobs: It is generally perceived to be a valuation strategy. In some market neutral strategies, however, the trading component can be the primary driver of profitability. For example, suppose an option is trading rich relative to the underlying security; one could short the option, acquire the underlying security, trade to rebalance the hedge over the life of the option, and unwind at a profit when the option matures. This type of option arbitrage is a valuation strategy, in the sense that the investment decision is based on relative valuation of the option and the underlying, but it is very trading intensive, with the timing of trades and minimization of trading costs being critical. The strategy may be considered to be more reliant on time and place advantages (with options traders in the pit having the upper hand) than on valuation. In general, however, most market neutral strategies do rely on discerning securities that are misvalued on a fundamental basis.
How, then, does market neutral differ from a typical strategy? Buchan: With traditional investing, the main issue is whether the security or securities held are going to go up or down in absolute terms. In market neutral investing, the focus is on relative valuation. (In fact, market neutral is sometimes called relative value investing.) This isnt so different from what many large institutional investors are already doing, when they manage their portfolios and measure performance relative to an underlying market benchmark, such as the S&P 500. Market neutral, however, goes one step further by essentially eliminating the market benchmark.
So market movements have no effect on the market neutral portfolio?
Levy: Market neutral portfolios are designed to offer performance that is independent of broad market moves. As with any investment strategy, the ability of market neutral to achieve its goal depends on the insights underlying the strategy and on proper implementation. In addition, certain, particularly extreme, market conditions can impinge upon the performance of market neutral strategies.
Buchan: For instance, in the 1987 market crash, many planned mergers fell apart as the shares of both would-be acquirers and targets fell in value. Market conditions thus affectedadverselythe performance of merger arbitrage strategies.
Jacobs: Long-Term Capital Management provides another example. This giant hedge fund was heavily involved in relative-value bond trades, having huge long positions in high-yield debt expected to rise in price and equally huge short positions in low-yield debt expected to fall in price. When Russia defaulted in the summer of 1998, however, investors worldwide were swept up in a flight to quality. Low-yield, safe securities, such as U.S. Treasury bills, soared in price, while the prices of higheryielding debt that was perceived as riskier plummeted. LTCM lost billions, as did other hedge funds and proprietary trading desks that had similar positions.
Levy: Because of their short positions, however, market neutral portfolios can react to extreme market conditions in ways that might seem counterintuitive to traditional long-only investors. For example, the 1987 equity market crash, which pounded the values of most long-only portfolios, provided liquidity for market neutral equity portfolios. The short positions in these portfolios profited from the price drop, offsetting losses on the long positions. Furthermore, the funds they had deposited with brokers to cover the value of the shares they had borrowed to sell short were now worth far more than the shares were worth. The securities lenders had to transfer excess cash collateral back to the market neutral accounts. Thus the liquidity of market neutral strategies can actually benefit from market crashes.
Buchan: Of course, any investment strategy is vulnerable to real-world challenges to the assumptions underlying it. The key is to anticipate such challenges and prepare for them.
If theres no market risk, where does the portfolio return come from?
Jacobs: A market neutral strategy is designed to be riskless in terms of its exposure to the relevant market benchmark. It retains the risks and returns associated with the individual securities constituting the portfolio. As these are both held long and sold short, their risks and returns will be offsetting to some degree. The return of the market neutral portfolio can be measured as the weighted return of the constituent securities or, in shorthand, as the spread between the long and short returns; portfolio risk can be measured as the standard deviation of these returns.
Buchan: The sources of risk, and return, will depend upon the particular strategy. For an option arbitrage strategy, risk and return are dependent upon changes in market volatility. A merger arbitrage strategy is exposed to the risk that a merger transaction will not be completed, as well as to the risk (shared by all investment strategies) that portfolio holdings will not perform as expected.
Cant neutrality be achieved by using futures, say, rather than by shorting securities?
Buchan: Yes, a manager could hold a long portfolio and short futures against it; as the underlying securities fall in value, the short futures position will rise in value (and vice versa), resulting in a return that is neutral to underlying market movements. This may be the best method for some specific market neutral strategies. For strategies that depend on security selection, however, the manager can generally enhance returns and gain greater control of risk by constructing a market neutral portfolio from long and short positions rather than achieving neutrality via a derivatives contract based on an underlying index.
Jacobs: This reflects the fact that long-only portfolios are generally constrained by the weights of the names in the underlying index, whereas market neutral long-short portfolios, if properly constructed, are free of index weights. This is most noticeable when you look at stock underweights. Given that the market capitalization for the median stock in the U.S. equity universe is 0.01% of the markets capitalization, a portfolio that cannot short can achieve, at most, a 0.01% underweight in the average stock; this underweight is obtained by excluding the stock from the portfolio. The manager may have a very negative view of the company, but the portfolios ability to reflect that insight is extremely limited. The manager that can sell short, however, can underweight this stock by as much as investment insights (and risk considerations) dictate.
Levy: Its important to note that the market neutral long-short portfolio also has greater leeway to overweight stocks, because the manager can use offsetting long and short positions to control portfolio risk. Whereas a long-only portfolio may have to limit the size of the position it takes in any one stock or stock sector, in order to control the portfolios risk relative to the underlying benchmark index, the market neutral long-short portfolio manager is not circumscribed by having to converge to benchmark weights to control risk. The freedom from benchmark constraints gives market neutral long-short portfolios greater leeway in the pursuit of return and control of riska benefit that translates into an advantage over market neutral portfolios constructed without shorting.
Can I neutralize my long-only portfolio by adding a short-only portfolio?
Buchan: Yes, but you would miss out on the real benefits of market neutral portfolio constructionthe added flexibility to pursue returns and control risks that comes from the ability to offset the risk/return profiles of individual securities held long and sold short.
Levy: Integrated portfolio optimization results in a single market neutral portfolio, not a separate long portfolio plus a separate short portfolio.
But a long portfolio combined with a short portfolio would be market neutral?
Jacobs: Yes, but it would offer little advantage over a long-only portfolio that achieved neutrality via derivatives positions.
Wouldnt it benefit from the diversification provided by a lessthan-one correlation between the returns on the long positions and the returns on the short positions?
Levy: But the same benefit can be achieved by adding to a long-only portfolio a less than perfectly correlated asset with similar risk and return. The unique advantages of market neutral long-short portfolios come only from an integrated optimization.
Will my portfolio be market neutral if I have equal amounts invested long and short?
Levy: Not unless the sensitivities of the positions held long and sold short are also equivalent. If the amounts invested are equal, but the betas are not, the portfolio will incur market risk (and returns). An investor might want to place a bet on the markets direction by holding larger and/or higher-beta positions long than short if the market is expected to rise, or vice versa if the market is expected to decline, but the portfolio in that case is not market neutral.
Buchan: It is also important to note that even a beta-neutral portfolio can retain residual exposures to certain market sectors. For example, long positions may overweight the technology sector, relative to the short positions, resulting in a portfolio that is exposed to systematic risk in this sector. A well-designed beta-neutral portfolio, however, will have such exposures only as the result of a deliberate choice on the part of the investor.
Jacobs: A similar problem arises in fixed-income market neutral. Market neutral fixed-income portfolios are generally designed to have matching durations for the longs and shorts; this means that, for a given parallel change in interest rates, price changes in the long and short positions will offset each other. If the term structure of interest rates does not change in a parallel fashion, however (for example, if long rates change less than short rates), price changes in the long and short positions will not be offsetting. It is thus important to determine the portfolios expected responses to movements in each part of the yield curve (the short rate, the 10-year rate) and in each sector (corporates, mortgages, etc.).
Arent short positions risky, or at least riskier than long positions?
Levy: Its true that the exposure of a long position is limited, because the securitys price can go to zero but not below. Theoretically, a short position has unlimited exposure because the securitys price can rise without bound. In practice, however, this risk is considerably mitigated. First, the short positions will be diversified across many securities. Second, a substantial (undesirable) increase in the price of a security that has been shorted will in all likelihood be at least partially offset by a (desirable) increase in the price of correlated securities held long. Third, because long and short positions must be kept roughly balanced to maintain neutrality, shorts are generally covered as they rise in price, limiting potential losses.
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