Market neutral
Encyclopedia
An investment strategy
or portfolio
is considered market neutral if it seeks to entirely avoid some form of market risk
, typically by hedging
. In order to evaluate market neutrality, it is first necessary to specify the risk being avoided. For example, convertible arbitrage
attempts to fully hedge fluctuations in the price of the underlying common stock
.
A portfolio is truly market neutral if it exhibits zero correlation
with the unwanted source of risk. Market neutrality is an ideal, which is seldom possible in practice. A portfolio which appears to be market neutral may exhibit unexpected correlations as market conditions change. The risk of this occurring is called basis risk
.
The strategy holds long/short equity positions, with long positions hedged with short positions in the same and related sectors, so that the equity market neutral investor should be little affected by sector-wide events. This places, in essence, a bet that the long positions will outperform their sectors (or the short positions will underperform) regardless of the strength of the sectors. Equity market neutral strategy occupies a distinct place in the hedge fund landscape by exhibiting one of the lowest correlation
s with other alternative strategies.
Evaluating the Hedge Fund Research index returns for 28 different strategies from January 2005 to April 2009 showed that equity market neutral strategy had the second lowest correlation with any of the other strategies, behind only short-bias funds that typically have a negative correlation with all other funds. This result is not surprising given that each fund utilizes the unique insights of a manager, and these insights are not replicated across funds.
Investment strategy
In finance, an investment strategy is a set of rules, behaviors or procedures, designed to guide an investor's selection of an investment portfolio...
or portfolio
Portfolio (finance)
Portfolio is a financial term denoting a collection of investments held by an investment company, hedge fund, financial institution or individual.-Definition:The term portfolio refers to any collection of financial assets such as stocks, bonds and cash...
is considered market neutral if it seeks to entirely avoid some form of market risk
Risk
Risk is the potential that a chosen action or activity will lead to a loss . The notion implies that a choice having an influence on the outcome exists . Potential losses themselves may also be called "risks"...
, typically by hedging
Hedge (finance)
A hedge is an investment position intended to offset potential losses that may be incurred by a companion investment.A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, many types of...
. In order to evaluate market neutrality, it is first necessary to specify the risk being avoided. For example, convertible arbitrage
Convertible arbitrage
Convertible arbitrage is a market-neutral investment strategy often employed by hedge funds. It involves the simultaneous purchase of convertible securities and the short sale of the same issuer's common stock....
attempts to fully hedge fluctuations in the price of the underlying common stock
Common stock
Common stock is a form of corporate equity ownership, a type of security. It is called "common" to distinguish it from preferred stock. In the event of bankruptcy, common stock investors receive their funds after preferred stock holders, bondholders, creditors, etc...
.
A portfolio is truly market neutral if it exhibits zero correlation
Correlation
In statistics, dependence refers to any statistical relationship between two random variables or two sets of data. Correlation refers to any of a broad class of statistical relationships involving dependence....
with the unwanted source of risk. Market neutrality is an ideal, which is seldom possible in practice. A portfolio which appears to be market neutral may exhibit unexpected correlations as market conditions change. The risk of this occurring is called basis risk
Basis risk
Basis risk in finance is the risk associated with imperfect hedging using futures. It could arise because of the difference between the asset whose price is to be hedged and the asset underlying the derivative, or because of a mismatch between the expiration date of the futures and the actual...
.
Equity market neutral
Equity market neutral is a hedge fund strategy that seeks to exploit investment opportunities unique to some specific group of stocks while maintaining a neutral exposure to broad groups of stocks defined, for example, by sector, industry, market capitalization, country, or region.The strategy holds long/short equity positions, with long positions hedged with short positions in the same and related sectors, so that the equity market neutral investor should be little affected by sector-wide events. This places, in essence, a bet that the long positions will outperform their sectors (or the short positions will underperform) regardless of the strength of the sectors. Equity market neutral strategy occupies a distinct place in the hedge fund landscape by exhibiting one of the lowest correlation
Correlation
In statistics, dependence refers to any statistical relationship between two random variables or two sets of data. Correlation refers to any of a broad class of statistical relationships involving dependence....
s with other alternative strategies.
Evaluating the Hedge Fund Research index returns for 28 different strategies from January 2005 to April 2009 showed that equity market neutral strategy had the second lowest correlation with any of the other strategies, behind only short-bias funds that typically have a negative correlation with all other funds. This result is not surprising given that each fund utilizes the unique insights of a manager, and these insights are not replicated across funds.