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Understanding the mechanics of market neutral investing

Understanding the mechanics of market neutral investing

September 2015

Our total return team examine how market neutral strategies can help reduce risk in a traditional portfolio.

01

Underpinnings of market neutral investing

Diversifying investments across mainstream asset classes is generally viewed as an effective way to navigate the peaks and troughs of the financial markets. Yet while harvesting the risk premia of bonds and stocks can deliver rewards over time, this approach is not entirely failsafe. Its heavy reliance on two sources of return can become a liability, particularly when fixed income and equity markets decline in lockstep. One way to mitigate the risks associated with a portfolio dominated by stocks and bonds is to allocate some of that capital to alternative investments. Provided such investments deliver returns that are genuinely uncorrelated with those of mainstream asset classes, their addition to a portfolio can help diversify sources of risk and return over the long run.
Market neutral strategies are alternative investments that exhibit such characteristics. Unlike other alternative investments, market neutral strategies aim to maintain low market risk, or limited sensitivity to shifts in the broader market, and high security-specific risk, or heightened exposure to the stock or bond selection skills of investment managers (Fig. 1).
FIG. 1 - MARKET NEUTRAL FOCUSES ON SECURITY-SPECIFIC RISK
MARKET NEUTRAL FOCUSES ON SECURITY-SPECIFIC RISK
Source: Pictet Asset Management


Their return objectives are consequently not tied to a reference benchmark; instead, they are usually expressed as a spread above a specific interest rate (eg Libor).

Managed well, such strategies can:
  • help investors secure returns that are not dependent on the trajectory of bond and stock markets
  • mitigate capital losses in a diversified portfolio during periods of market stress
  • improve the risk-adjusted return of a traditional balanced portfolio consisting of stocks and bonds
While the concept is not new, market neutral strategies can be expected to serve the needs of a broader group of investors in the future. This is largely because the deployment of ultra-loose monetary policy has caused profound changes across the investment landscape, transforming the risk-return profile of mainstream asset classes. Among the challenges investors face are:

Fixed income risk premia a potentially more volatile source of return.
Yields on developed market government bonds and investment grade credit sit well below the historical norm. But with inflation and interest rates unlikely to fall much further, returns from fixed income look set to be lower and more volatile than has been the case over the past 30 years.

High equity valuations may limit future returns.
Over the next five years, we expect inflation-adjusted returns for developed market stocks to be below average. Valuations – as measured by price-earnings ratios – are already high by historical standards in many developed stock markets, potentially limiting the scope for further gains. Moreover, corporate earnings growth can also be expected to be muted as real economic growth remains below par.

02

The mechanics of market neutral investing

Breaking down the return

The return generated by a traditional long-only actively-managed portfolio has two components to it: beta, or the investment gain attributable to market returns, and alpha, the excess return that stems from the skill of the investment manager. Under a market neutral approach beta, or market risk, is minimised and alpha, or securityspecific risk, is maximised by giving managers the discretion to build both long and short positions.
FIG. 2 - THE MECHANICS OF LONG/SHORT INVESTING
A hypothetical USD100 investment
THE MECHANICS OF LONG/SHORT INVESTING - A HYPOTHETICAL USD100 INVESTMENT
Source: Pictet Asset Management
By enabling investment managers to express both positive and negative views, security selection skills are exploited to the full. There is a clear logic to this: high-quality investment research not only unearths the securities that will outperform, it identifies the future laggards too. In principle, the aggregate beta of the short positions in a market neutral portfolio should be roughly equal the aggregate beta of the long investments.

So, provided the investment manager has selected the right securities, the gains from the long positions should outweigh losses from the short investments in a rising market; if the market falls, the gains from short positions will be greater than the losses in the long investments (Fig.2). The return of a market neutral strategy, then, is the difference in return between the long and short book – or spread.

03

Historic risk and return patterns for market neutral funds

Market neutral strategies exhibit distinct patterns of return

In seeking to generate investment gains almost exclusively from the performance of individual securities, market neutral strategies have acquired some distinctive characteristics.

Market neutral strategies' returns are rarely in sync with those of mainstream asset classes (Fig. 3).  
FIG. 3 - MARKET NEUTRAL VS. GLOBAL EQUITIES
Returns, %, in 5 best and worst months for stocks since 2005
MARKET NEUTRAL VS. GLOBAL EQUITIES
Source: Bloomberg, Pictet Asset Management. Returns in US dollars, covering period 30.04.2005-30.04.2015


This is also laid bare in a comparison of the instantaneous variance of returns generated by market neutral strategies and global stocks. In this analysis, instantaneous variance is calculated by squaring monthly returns.
As Fig. 4 shows, market neutral and world equities experience spikes and troughs in variance at different times. This suggests that the factors responsible for the volatility of market neutral funds are different from those that influence equity markets.
FIG. 4 - RETURN VARIANCE: MARKET NEUTRAL VS WORLD STOCKS
Monthly returns, %, squared
RETURN VARIANCE: MARKET NEUTRAL VS WORLD STOCKS
Source: Bloomberg. Pictet Asset Management. Returns in USD; data covering period 30.04.2005-30.04-2015.
This distinct return pattern helps explain why market neutral strategies can diversify sources of risk and return in a broad portfolio. It is also a source of stability. History shows that market neutral portfolios can offer investors a considerable degree of capital protection during bear markets relative to mainstream asset classes. 

Over the past 20 years, the peak-to-trough loss, or drawdown, among market neutral strategies has been far shallower than that of equities and compares favourably to that of fixed income (Fig. 5).
FIG. 5 - DRAWDOWNS: MARKET NEUTRAL VERSUS BONDS AND STOCKS
DRAWDOWNS: MARKET NEUTRAL VERSUS BONDS AND STOCKS
Source: Bloomberg, Pictet Asset Management. Data covering period 30.04.1995-30.04.2015; returns in USD


Market neutral funds have also experienced lower volatility than either bonds or stocks while their risk-adjusted returns have also been higher than mainstream assets over the long run (Fig. 6).
FIG. 6 - VOLATILITY AND RETURNS: MARKET NEUTRAL VS BONDS AND STOCKS
Data covering period 30.04.2005-30.04.2015; volatility calculated on a 12-month rolling basis, returns in USD
VOLATILITY AND RETURNS: MARKET NEUTRAL VS BONDS AND STOCKS
Source: Bloomberg, Pictet Asset Management

04

Market neutral investing – degrees of neutrality

Not every strategy that exhibits low beta can claim to be impervious to the fluctuations in the broader financial market. That is because beta and correlation are not perfect measures of market risk.

There are, in fact, a number of systematic-like risks that have a bearing on the returns of stocks but are not adequately captured by conventional indicators of neutrality such as beta.

Examples include country, sector, currency and style exposures.

Strategies run by investment managers that either ignore – or systematically harness – these risk factors may struggle to maintain their neutrality across all phases of the market cycle. For example, returns will suffer if a certain style falls out of favour.

Another risk that can taint a strategy’s neutrality is liquidity. Securities are not universally liquid, and history shows that illiquid stocks tend to outperform their more liquid counterparts over time. Skewing a portfolio’s long positions towards illiquid stocks might therefore have some appeal. But the strategy can land investors in trouble, particularly during episodes of market stress, as illiquid securities tend to suffer most in such instances.

The introduction – or mismanagement – of systematic biases is perhaps one reason why the risk-return profile of market neutral strategies differs considerably from fund to fund.

For prospective investors, the lessons are clear: Some market neutral strategies are more neutral than others. 

05

Key takeaways

Market neutral strategies can:

Help investors secure returns that are not dependent on the trajectory of bond and stock markets

Their returns are dependent on the skills of investment professionals, not on moves in the broader financial market.

Mitigate capital losses in a diversified portfolio during periods of market stress

By enabling investment managers to express both positive and negative views, security selection skills are exploited to the full.

Improve the risk-adjusted return of a traditional balanced portfolio consisting of stocks and bonds

Provided such investments deliver returns that are genuinely uncorrelated with those of mainstream asset classes, their addition to a portfolio can help diversify sources of risk and return over the long run.