New York (HedgeCo.Net) Market neutral is a core investment strategy typically implemented by hedge funds focused on eliminating overall market risk. While the end goal remains the same, managers will employ differing market neutral methods such as sector, beta, market capitalization, and dollar neutral strategies.
A market neutral manager’s fundamental ideal is to achieve an absolute return investment profile and mitigate relative returns, often making market neutral strategies a suitable “bond substitution” option and a good candidate for employing leverage. The low correlation to the overall market, and typically to other hedge fund strategies, makes market neutral managers an ideal addition to almost any hedge fund portfolio seeking a diversified portfolio of strategies. The strategy has also historically weathered market volatility very well, by reducing a portfolio’s volatility at times when other strategies suffered from significant swings.
While there are different approaches for market neutral strategies, the ultimate goal for almost all of them is the same: remove as much overall market risk as possible.
Returning to the idea of a beta neutral strategy, HedgeCoVest recently interviewed Jon Angrist from Cognios Capital and he offered a great explanation of what Beta-adjusted market neutral means. “We use a Beta-adjusted market neutral. This allows us greater precision in hedging out all of the Beta of the broad stock market, which is ultimately the goal of being market neutral. For example, if the Beta of our long book is 1.0, but the Beta of our short book is 1.5, we don’t need $100 of short positions for every $100 of long positions to hedge out all of the market Beta. In fact we only need $66 in the short book because of the higher Beta of the short book. The $66 is determined by the ratio of the two Betas (i.e., 1.0 / 1.5 = 66%). By Beta adjusting the size of the short book, the total return of our portfolio should be pure alpha,” Angrist stated.
Studies suggest that market neutral strategies are especially attractive during times of increased volatility in the overall market as the goal of the strategy is to eliminate overall market risk. It stands to reason that if volatility is rising, the overall market risk is rising and by removing it or by removing as much of it as possible, the underlying portfolio should outperform the overall market.
Using the CBOE Volatility Index (VIX) as an indicator of overall market volatility, you can see that volatility was muted throughout 2013 and through the first three quarters of 2014, but volatility is on the rise. The VIX didn’t move above the 22 level for over 20 months during the stretch in 2013-14. However, the VIX has moved above the 22 level during nine different weeks over the last six months.
It should also be pointed out that the VIX appears to be in an uptrend based on the series of higher lows the indicator has put in over the nine months. If this proves to be the case and volatility continues to rise, having a market neutral strategy as part of your portfolio could give you greater protection from the downside risk that would come from another bear market.
HedgeCoVest offers several models that are market neutral strategies and several of them use beta to evaluate their overall market risk and exposure. This is yet another way that HedgeCoVest can be used to complement your traditional portfolio construction
