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Aren't market neutral strategies best exploited only in certain situations or by investors with special information?
If youre using short positions to create a market neutral strategy, doesnt that mean the strategy must be leveraged?
Jacobs: Not necessarily. The amount of leverage of a given strategy is within the investors control. Although Federal Reserve Board Regulation T permits leverage of up to two-to-one for equity strategies, for example, the investor can choose not to lever. Thus, given an initial $100 in capital, the investor could invest $50 long and sell short $50; the amount at risk is then identical to that of a $100 long-only investment.
Then wouldnt you want to avoid leverage in order to avoid the risk it entails?
Buchan: Actually, some leveraged market neutral strategies may be much less risky than unleveraged long-only strategies. For example, shorting a Treasury bond futures contract and owning the bond that is deliverable against the futures contract at expiration is a much less risky strategy than a long-only small-cap equity strategy. Furthermore, restricting the choice of market neutral strategies to those that are unleveraged can produce a leverage paradox, whereby, in order to achieve a desired return, one may end up choosing an unleveraged strategy that is inherently riskier than a strategy that could be levered up to produce the same return at less risk.
Jacobs: In addition, by using all the strategies out there at the appropriate leverage levels (which for some may be no leverage), you can take advantage of the typically low correlations among all the strategies, rather than just a subset. This will produce the least risky portfolio of strategies, as you have the opportunity to diversify risks across many different markets.
Levy: Furthermore, long-only portfolios can use leverage, too. However, long-only strategies that borrow to leverage up returns expose the otherwise tax-free investor to a possible tax liability, as gains on borrowed funds are taxable as unrelated business taxable income. Borrowing stock to initiate short sales does not constitute debt financing, so profits resulting from closing out a short position do not give rise to unrelated business taxable income (UBTI).
Buchan: In general, when judging any market neutral strategy, the question should be whether the level of leverage is prudent with respect to the strategy. Clearly, if the strategy involves buying Asian technology stocks and shorting European financial stocks, there is a significant amount of risk (so much, in fact, that few investors would consider such a strategy market neutral). Conversely, if the strategy involves buying stock in a company and then shorting the same companys American Depositary Receipt (ADR) against the long position, the risk would be relatively small.
Jacobs: The same is true for fixed-income arbitrage: The level of prudent leverage is dependent upon the strategy. Buying Japanese government bonds and shorting European corporate securities is very risky; not only are the corporates inherently riskier (and less liquid), but youre arbitraging between two very different interest rate regimes. But buying U.S. Treasuries and selling short Eurodollar futures (buying a so-called TED spread), is not, as a trade, very risky.
Buchan: Basically, its not the leverage per se that matters, but rather the leverage times the risk of the underlying position; or, more succinctly, its the net exposure that matters.
So some market neutral strategies are riskier than others?
Buchan: Clearly, but this is true of investment strategies in general. With market neutral, the riskiness depends to a large extent on the underlying instruments. Mortgage securities, for example, are commonly perceived as quite a bit riskier than government bonds. Even here, however, it is difficult to generalize. Mortgage securities cover a wide range, from highly liquid pass-throughs to unique tranches of collateralized mortgage obligation (CMO) deals; therefore, it is misleading to lump all the different types of mortgage securities in the same group. Many mortgage securities are exposed to liquidity risk and prepayment risk (or, in more formal terms, exhibit negative convexity), and may be difficult to value. But some familiarity with these securities reveals that they are not that different from other types of bonds. Take the prepayment risk: as individuals prepay their mortgages, pass-through securities exhibit negative convexity; when interest rates fall, they increase in value by less than a similar fixed-rate government investor is compensated for these adverse outcomes with a higher yield. Thus, the salient question for the pass-through investor is whether the yield on the security adequately compensates for the adverse price risk.
Levy: This is essentially no different from ordinary government bonds. Zero-coupon bonds, for example, have lots of positive convexity, on a relative basis, and will therefore often yield less than coupon bonds. There are also liquidity and valuation issues, just as with corporate bonds. Most corporate bonds are illiquid, in the sense that it can cost a lot to trade them. By this measure, many mortgage securities are actually more liquid than corporates. In addition, in valuing a corporate bond, one has to estimate the probability of default and the corresponding likely recovery ratesjust as one has to estimate future mortgage prepayment rates under differing economic scenarios.
Buchan: So mortgage securities are different from but, in general, not necessarily riskier than other bonds used in market neutral strategies.
Jacobs: Kens comment about the liquidity of corporates reminds me that one should also take into account, when evaluating the risk of a particular strategy, the liquidity of the underlying markets, which may be of critical importance especially for highly leveraged strategies. And another concern I might add is the availability of opportunities in a particular strategy; to the extent that this may limit the ability to diversify ones portfolio, it can have a considerable impact on risk.
Arent market neutral strategies best exploited only in certain situations or by investors with special information?
Jacobs: Ive heard it said that market neutral equity strategies only make sense if pricing inefficiencies are larger or more frequent for potential short positions (that is, among stocks that tend to be overpriced) than for potential long positions (stocks that tend to be underpriced). But greater inefficiency of short positions is not a necessary condition for market neutral investing to offer benefits compared with long-only investing. These benefits reflect the added leeway to pursue return and the greater control of risk that derive from the strategys freedom from benchmark weight constraints.
Levy: Its also frequently heard that merger arbitrage does not work unless its based on insider information. But, as it is practiced in the institutional investment community, merger arbitrage is usually based on a public announcement, where the identity of the target, the identity of the buyer, and the rough terms of the transaction are disclosed. Even after such an announcement is made, a spread between the acquirer and the target tends to persist until the deal closes. This spread reflects the very real risks that the deal will not close or, if it does close, it will take a lot longer than expected, reducing the investors annualized return. Managers able to analyze these risks correctly have been able to use merger arbitrage to add significant value on a risk-adjusted basis over the past decade.
Buchan: A lot of people think convertible bond hedging follows a fouryear cycle in terms of returns. Historically, the strategy has underperformed for a quarter or two every three to four years, in 1987, 1990, 1994, 1998, and 2002, and then proceeded to enjoy a strong recovery in the ensuing year. But whats behind this pattern? Some of the returns to convertible bond hedging may come from a liquidity premium the convertible holder collects in return for holding a relatively illiquid security. If this is the case, then we should see convertible bond hedgers underperforming when liquidity is prized, as these less liquid assets get marked down. In fact, regressing the return of convertible hedgers as a universe on a liquidity measure (such as the spread between Treasury bills and LIBOR) shows that, when the most liquid instruments are highly valued, convertible bond hedging does poorly for the quarter (typically down 2% to 7%). So the question is not whether convertible bond hedging has an inherent four-year cycle but, rather, what makes highly liquid instruments more valuable every four years?
But wont market neutral long-short positions be riskier in general than the positions taken by an index-constrained long-only portfolio?
Jacobs: Although a market neutral long-short portfolio may be able to take larger long (and short) positions in securities with higher (and lower) expected returns compared with a long-only index-constrained portfolio, proper integrated optimization will provide for selections and weightings made with a view to maximizing expected return at the risk level desired by the investor.
But surely trading costs will be higher?
Levy: The trading costs will largely be a reflection of the leverage in the portfolio. If a market neutral equity portfolio takes advantage of the full two-to-one leverage allowed, for example, it will engage in roughly twice as much trading as a comparable long-only portfolio with the same capital and no leverage. As in any investment strategy, however, it is important in market neutral to estimate expected returns net of trading costs. A market neutral portfolio should not trade unless those trades offer a return above and beyond the cost of trading.
But surely management fees will be higher for market neutral than for long-only strategies?
Jacobs: If one considers management fees per dollar of securities positions, rather than per dollar of capital, there is not much difference between market neutral and long-only. And management fees per active dollar managed may be lower with market neutral than with long-only. Index-constrained long-only portfolios contain a substantial hidden passive element; as their active positions consist of only those portions of the portfolio that represent overweights or underweights relative to the benchmark, a large portion of the portfolio is essentially passive index weights. This is not true of market neutral. Because a market neutral portfolio is independent of benchmark weights, its positions can be fully devoted to performance (i.e., to either enhancing return or reducing risk).
Levy: Also, most market neutral strategies are managed on a performance-fee basis, so the fee will reflect the managers value-added.
Should one use a single manager or multiple managers for a market neutral strategy?
Jacobs: Some investors choose to create a market neutral strategy by combining a long-only portfolio with a short-only portfolio or with a derivatives position that neutralizes the long portfolios market risk. In these cases, the manager of the long portfolio may differ from the manager of the short portfolio or from the overlay manager that looks after the derivatives positions. As we have noted, however, these types of market neutral strategies cannot benefit from the full flexibility afforded by long-short portfolio construction. This goes back to our previous comments on integrated optimization: Only an integrated optimization, which considers long and short positions simultaneously, results in a portfolio that is free of benchmark weight constraints, hence able to exploit fully the risk-reducing and return-enhancing benefits of market neutral construction using long and short positions. An investor seeking these benefits from a market neutral strategy should have it managed under a single roof.
Buchan: But the same may not hold if you are considering multiple market neutral strategies. In general, the value-addeds are much less correlated across market neutral managers than across long-only equity managers. The reason is there are many more styles of market neutral investing (over 20) than there are of equity investing (growth vs. value, large cap vs. small cap). As long as the managers have the same expected return, one can lower the risk of an overall fund more by using many market neutral managers than by using many long-only equity managers.
Is market neutral too complicated for most investors to understand?
Buchan: There are two parts to market neutral investingthe strategy and the securities. As I have noted, the strategy itself is typically no more complex than what is being done on a long-only basis, with regard to benchmark-relative investing. There, the issue is how the portfolio will perform relative to the benchmark; here, the issue is how one security (or basket of securities) will perform relative to another. The other issue is the type of securities used to implement the market neutral strategy. Clearly, there are securities that are simple to evaluate and securities that are more complex. But this is independent of whether or not they are being used in a market neutral strategy.
How will it fit into a plans overall structure?
Jacobs: First, it is important to understand that market neutral does not constitute a separate asset class. The asset class to which a market neutral portfolio belongs depends upon how the portfolio is constructed. A market neutral portfolio is essentially a cash investment (albeit with higher volatility than cash); its value-added is the portfolios return relative to the interest receipts from the short sale proceeds. But one can combine a market neutral portfolio with various derivatives positions to obtain exposures to any number of assetsequity, bonds, currency. For example, a position in stock index futures combined with a market neutral portfolio results in an equitized portfolio; its value-added is the portfolios return relative to the equity index return from the futures position.
Levy: Plan sponsors can take advantage of this flexibility to simplify a plans structure. Using market neutral, they can exploit superior security selection skills (whether in the bond market, the stock market, or the currency market), while determining the plans asset allocation mix separately, via the choice of derivatives. In this sense, market neutral can be said to simplify a plan sponsors decision-making.
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