Market-neutral investment strategy is often used to reduce portfolio’s volatility and achieve a low Beta. Eliminating all risk in the volatile world of equity trading is a lofty, but somewhat achievable goal. Volatility in the equity markets is a fact of life. In a portfolio of 60% equities and 40% fixed income products, for example, most of the volatility will tend to emanate from the equity portion.
Hedge fund managers employ a diverse range of investment strategies intended to reduce risk and to earn a positive return in virtually any circumstance. Their mission is to protect and grow portfolios in spite of serious market swings.
What is a market-neutral investment strategy?
An equity market-neutral (EMN) strategy employed by a hedge fund targets positive results that are insulated from overall equity market volatility. The essence of this investment approach is to creatively balance positions in stocks that will outperform their peers with short positions in other stocks that will underperform.
In any scenario, if the long side of the investment matches the short side, the investment is market-neutral.
The actual long versus short positions in an EMN investment may not be equal in monetary value to reduce the effects of market volatility. Balancing the positions relative to their Beta to minimize volatility of each side is needed to bring the overall volatility risk as close to zero as possible.
In market terms, the objective of a market-neutral investment strategy is to achieve 0 Beta in relation to the broader market and significant Alpha, which is defined as the yield beyond average market return.
How does the strategy work?
An investment manager may create a market-neutral balance with hundreds of different equities on each side of the investment.
For simple demonstration, however, consider a scenario with two stocks in the same industry, General Motors (GM) and Fiat Chrysler Automobiles (FCAU), and an available investment of $100,000.
Using these two stocks, GM (General Motors) and FCAU (Fiat Chrysler Automobiles), the hedge fund manager elects to work on the premise that GM’s new offerings will do better in the coming months than FCAU’s.
First, the manager will examine the Beta, or volatility rating, of each stock to determine how he must balance the investments. If the Beta for both equities happens to be the same, then the manager will place $50,000 in GM stock and allocate $50,000 to an FCAU short position to create a 0 Beta for the entire investment.
If, on the other hand, GM has a Beta of 1.0 and FCA’s Beta is 2.0, then the investment manager will balance the investment with $66,666 long (stock purchase) for GM and $33,333 in a short position for FCA to create a neutral or 0 Beta position.
Suppose the market begins to sell off. After a few months, the gain in the short position in FCAU has offset the drop in the GM long position. The overall investment remains as it began.
After more time, GM’s new products are taking hold and GM stock moves up 5% while the FCA stock continues to drop another 3%. At this point, the overall investment has gained:
5% x ($66,000) + 3% x ($33,000) = $4,333.00 or 4.33%.
If the market had risen after the positions were taken, the long position would have similarly offset the short position.
The best hedge fund managers know when to liquidate the positons to optimize the investment.
How is the investment manager compensated?
Investment and hedge fund managers are generally compensated according to their success. In many instances in Canada and the United States, the 2-and-20 rule applies in which the manager receives 2% of the assets under management and 20% of the profits earned. Some hedge fund managers are salaried and compensated with bonuses based upon the profits generated. But even this formula varies from fund to fund.
Are market-neutral investment strategies widely used?
As market uncertainty increases, market-neutral investment strategies are more widely used. While there is no guarantee of profits, essential capital preservation removes much of the worry that accompanies uncertain times. Concerns about currencies, interest rates, emerging markets and other potential problems tend to drive investors toward a defensive mode.
We hope you found this article on market-neutral investment strategy useful. If you have any questions about Hedge Fund investing in Canada or if you would like to learn more about our Montreal based hedge fund, we invite you to contact us today. It will be our pleasure to answer your questions.