What Is Market Neutral?
I'm here to explain market-neutral strategies directly to you. A market-neutral strategy is an investment approach that you or an investment manager might use to profit from both increasing and decreasing prices in one or more markets, all while trying to completely avoid some specific form of market risk.
You achieve market-neutral strategies often by taking matching long and short positions in different stocks. This increases the return from making good stock selections and decreases the return from broad market movements.
Key Takeaways
Let me break this down for you assertively: Market neutral refers to a type of investment strategy that investment managers use to profit from both increasing and decreasing prices in the financial markets. It's known as a market-neutral strategy because the investment selections seek to avoid significant losses, with the long and short positions serving as a hedge to one another.
You see, market-neutral strategies are often employed by hedge funds since their investment objective is absolute returns rather than relative returns. The two main types that fund managers employ are fundamental arbitrage and statistical arbitrage. Importantly, market-neutral strategies have one of the lowest positive correlations to the market because they place specific bets on stock price convergences while hedging away the general market risk.
Understanding Market Neutral
There's no single accepted method for employing a market-neutral strategy, and I'll tell you why. Beyond the basic method of long and short positions, you as a strategist might also use tools like merger arbitrage or shorting sectors.
If you're a manager holding a market-neutral position, you can exploit any momentum in the market. Hedge funds commonly take this position because they focus on absolute returns over relative ones. For instance, you might take a 50% long and 50% short position in a particular industry like oil and gas, or in the broader market.
People often compare market-neutral strategies to long/short equity funds, but they're distinctly different. Long/short funds simply vary their long and short stock exposures across industries to take advantage of undervalued and overvalued opportunities. Market-neutral strategies, however, focus on making concentrated bets based on pricing discrepancies, with the main goal of achieving a zero beta versus the appropriate market index to hedge out systematic risk. While both use long and short positions, the goals of market-neutral funds are different from plain long/short funds.
Types of Market-Neutral Strategies
There are two main market-neutral strategies that fund managers employ, and I'll outline them for you. Fundamental arbitrage involves using fundamental analysis, rather than quantitative algorithms, to project a company's path forward and make trades based on predicted stock price convergences.
On the other hand, statistical arbitrage market-neutral funds use algorithms and quantitative methods to uncover price discrepancies in stocks based on historical data. Then, based on these quantitative results, managers place trades on stocks that are likely to revert to their price means.
A key benefit of market-neutral funds is their emphasis on constructing portfolios to mitigate market risk. In times of high market volatility, historical results show that these funds are likely to outperform those using other strategies. Except for pure short-selling strategies, market-neutral strategies historically have the lowest positive correlations to the market because they place specific bets on stock price convergences while hedging away general market risk.
Example of a Market Neutral Fund
Let me give you a concrete example. Because it is a market-neutral strategy, the Vanguard Market Neutral Investor Shares Fund (VMNFX) is a liquid alt fund that uses long and short-selling strategies, unlike the firm's other mutual funds, which only buy and sell long positions. The fund's strategy aims to minimize the impact of the stock market on its returns, meaning the fund's returns may vary widely from those of the market.
Although most funds that short stocks, such as hedge funds, do not disclose their short holdings because SEC rules do not require them to, this Vanguard fund does publish its shorts. It chooses short positions by evaluating companies in five categories: growth, quality, management decisions, sentiment, and valuation. Then, it creates a composite expected return for all stocks in its universe and shorts those with the lowest scores.
Investing in these market-neutral specific funds is typically for high-net-worth individuals. For example, VMNFX has a minimum investment amount of $50,000. Other funds may have extremely high expense ratios, well above those of passively managed funds.
