Diversification is one of the best-known and established methods for reducing risk in a portfolio. However, in these current times of globalisation, we have seen increasing correlation between equities in different markets and sectors. Thus, even a highly diversified portfolio is proving less effective in shielding against market risk. Against a backdrop of geopolitical tensions, rising inflation and concerns over growth, a market-neutral strategy could be a strategy worth considering.
What is a market-neutral strategy?
Compared to long or short portfolios that seek relative returns against a benchmark, a market-neutral strategy combines both long and short positions with the aim of absolute returns — regardless of the general direction of the market. The long and short positions are of equal exposure, so, in the event of a fall in the general markets, the losses in the long positions would be offset by gains in the short positions, and vice versa.
At this point, you may ask, how does one generate returns if gains are offset by losses whichever direction the market goes? This is where stock picking comes into play. While market risk has been diversified away, it is entirely possible for the long or short positions to outperform, thus, generating a return.
Here is an example. If a portfolio manager has a market-neutral portfolio of $10,000 split 50-50 in long and short positions, and the S&P500 drops 10%, it is entirely possible, due to skilled selection, that the long positions in the portfolio outperform the index and drop 5%. If the short positions perform in line with the index and hence gain 10%, then the long positions would be worth $4,750 while the shorts $5,500, adding up to $10,250, resulting in a return of 2.5% despite a fall in the markets. Of course, it is also possible for the long or shorts to underperform, resulting in an absolute loss no matter what the direction of the markets. Therefore, picking stocks that outperform is of crucial importance in making positive absolute returns while employing a market-neutral strategy.
Advantages and disadvantages
As we can see from the example above, in difficult or falling markets with high volatility, a market-neutral strategy can become an excellent way to reduce portfolio volatility.
Another advantage of being market-neutral is that such a strategy allows for more freedom than traditional long-only investing. Traditional long-only investors could not open any short positions whatsoever even as the market was plunging. They could not generate any return from a stock they deemed poised to fall. However, investors employing market-neutral strategies could combine long positions on stocks set to outperform with short positions on overvalued companies, potentially enhancing returns, especially if both bets pay off.
Market-neutral is an excellent way to reduce portfolio volatility and present good risk-reward, however, it is still non-directional. This means that in a rapidly rising market, one could not profit from a general increase in asset prices, and in a rapidly falling market, one could not benefit as much as a net short portfolio would. In fact, in fast-moving, directional markets, asset prices usually tend to have higher correlation as people become extremely risk-seeking or risk-averse. This means there is less spread between the best- and worst-performing stocks, and could result in lower returns in employing a market-neutral strategy.
Therefore, the chief objective for an investor using a market-neutral strategy in volatile markets is not the maximisation of returns, but rather, stability and hedging. At the same time, the disadvantage of being market-neutral is clear: in a rising market, one would miss out on potential gains from a general increase in asset prices, and that could well be greater than the absolute returns from differences in individual price movements.
Part of a balanced portfolio
Capable portfolio managers do not limit themselves to a single strategy at all times. It is plausible to devote only a portion of a portfolio to a market-neutral strategy, such as in core-satellite investing as a way of enhancing gains as compared to an otherwise long, passive portfolio. It is also entirely plausible, perhaps even wise, for a portfolio manager to adapt their approach to current market conditions, and use a market-neutral strategy only when it’s deemed beneficial.
Switching to such a strategy is simple. It might not be the most convenient switching for the portfolio to be 50-50 long-short in position size, however, one could make use of derivatives or margin instead to achieve parity in exposure. For example, if you were to switch from a long-only portfolio to become market-neutral, instead of a major portfolio rebalance, you could simply open a small short position with high leverage to achieve the short exposure required. Don’t forget, however, that margin trading requires using borrowed money and incurs interest, which should be taken into consideration when calculating returns. It is not recommended to maintain highly-leveraged positions for long periods of time.
Conclusion
In conclusion, market-neutrality can be a great tool in any portfolio manager’s arsenal. It adds a further layer of diversification and greatly reduces the market risk of a portfolio. It can be employed to both reduce overall portfolio volatility, as well as maximise returns through shorting underperforming companies and going long on those outperforming. Market conditions can change faster than the British weather, as we have witnessed recently, and employment of a market-neutral strategy could be the all-weather option you’re looking for.
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