This is typically done by simultaneously holding both long and short positions in the market, with the goal of generating returns that are not correlated to the overall market.
One way that market-neutral funds can achieve this is by actively managing a portfolio of stocks both long and short and also using financial instruments such as options or futures contracts to hedge the various risks associated with those positions.
The portfolio is typically constructed to have an overall market beta of zero, meaning that the portfolio is not expected to be affected by market movements at the broadest level.
Market-neutral funds can also achieve market neutrality is by using a statistical arbitrage strategy. In this case, the fund seeks to exploit price discrepancies between two securities or groups of securities (e.g., an ETF and the underlying group of stocks).
By buying and selling these securities in a way that is mathematically calculated to be market neutral, the fund can generate returns that are not correlated to a common benchmark index (e.g., the S&P 500).
Market-neutral funds can be useful for investors who are looking to diversify their portfolio and reduce the overall market risk of their investments.
However, it is important to note that these funds do have risk like all other investments, as the positions they take may not generate excess return over a representative benchmark (or gain any return at all).
On to of that, they may still be exposed to other types of risk such as credit risk or liquidity risk.
We’ll take a broader look at market-neutral strategies in this article.
Market Neutral Strategies
Below are some market-neutral strategies:
Equity Market Neutral Funds
Equity market-neutral funds are investment vehicles that aim to generate returns that are uncorrelated to the overall stock market.
These funds typically seek to achieve this goal by constructing portfolios that are equally long and short various stocks.
They will often control for the duration of the underlying positions, as some stocks are more volatile and sensitive to changes in interest rates (among other factors). This will help to effectively neutralize the market exposure of the portfolio.
In order to construct a market-neutral portfolio, a fund manager will first identify a group of stocks that are expected to perform well and a group of stocks that are expected to underperform.
The fund will then take long positions in the expected winners and short positions in the expected losers (or underperformers), in an attempt to profit from the difference in performance between the two groups of stocks.
One of the key advantages of market-neutral funds is that they can potentially provide investors with a source of returns that is not dependent on the direction of the stock market.
Accordingly, you often see market-neutral hedge funds, which are expected to give returns that are uncorrelated with traditional investments.
This can be especially appealing in times of market volatility or economic uncertainty, when it may be difficult to predict which stocks will outperform.
However, market-neutral funds can also be more complex and risky than other types of investments.
For example, short selling involves selling borrowed securities in the hope that the price will decline, which can be a more risky strategy than simply buying and holding stocks.
Market-neutral funds may also incur higher fees due to the need to constantly rebalance the portfolio to maintain market neutrality.
Quantitative Market Neutral Funds
Quantitative market-neutral funds are investment vehicles that aim to generate returns that are independent of the overall direction of financial markets.
These funds typically use advanced statistical techniques, such as quantitative analysis and machine learning, to identify and exploit mispricings in the market.
To achieve a market-neutral position, these funds typically hold long and short positions in a variety of assets, with the goal of canceling out the overall market exposure of the portfolio.
For instance, if a fund holds a long position in one security and a short position in another security that are perfectly correlated, the net market exposure of the portfolio will be zero.
An example of this would be spotting a mispricing between an ETF and the underlying positions within it.
There are a few different approaches that quantitative market-neutral funds can take to identify mispricings in the market.
Some funds may use fundamental analysis to identify companies that are undervalued or overvalued relative to their intrinsic value.
Others may use certain types of technical analysis to identify trends and patterns in the market (e.g., who’s buying and who’s selling and for what reasons), and then take long or short positions based on their expectations of how those trends will play out.
One of the main benefits of quantitative market-neutral funds is that they can potentially generate returns in a variety of market conditions.
Because these funds aim to be market neutral, they are not exposed to the overall direction of the market, and can potentially generate returns even when the market is declining.
However, it is important to note that these funds are not without risk, and it is always important to carefully consider the risks and potential rewards of any investment before making a decision.
When a company announces that it plans to acquire another company, the target company’s stock price may rise above the price offered by the acquiring company, due to investors’ expectations that the acquisition will be completed and that the target company’s stock will eventually be worth the offer price.
Merger arbitrageurs aim to take advantage of this price discrepancy by purchasing the target company’s stock and holding it until the acquisition is completed.
If the acquisition goes through as planned, the arbitrageur can then sell the stock for a profit.
However, if the acquisition falls through or the offer price is changed, the stock price may drop, resulting in a loss for the arbitrageur.
There are a few different approaches that merger arbitrageurs can take.
Some may focus on identifying companies that are likely to be acquired, while others may take a more opportunistic approach and look for any discrepancies in prices that may arise during the course of a merger or acquisition process.
Merger arbitrage can be a risky strategy, as there are many factors that can influence the success or failure of an acquisition.
However, it can also offer the potential for attractive returns, particularly in a market with a high level of M&A activity.
Fixed Income Arbitrage
Fixed income arbitrage is a type of trading strategy that aims to profit from discrepancies in the prices of fixed income securities.
These discrepancies can occur due to a variety of factors, including differences in interest rates, credit risk, and liquidity.
There are several different approaches to fixed income arbitrage, but one common approach is to identify pairs of fixed income securities that are similar in terms of their risk and return characteristics, but are trading at different prices.
For example, a trader might look for two bonds with similar credit ratings, maturity dates, and coupon rates, but different prices.
If the trader believes that one of the bonds is undervalued relative to the other, they can buy the undervalued bond and sell the overvalued bond, hoping to profit from the difference in prices.
This strategy is known as a “convergence trade,” because it involves betting that the prices of the two bonds will eventually converge, or move closer together.
Other types of fixed income arbitrage strategies include yield curve arbitrage, which involves taking advantage of differences in the shape of the yield curve, and duration arbitrage, which involves betting on changes in the duration, or sensitivity to changes in interest rates, of different fixed income securities.
Fixed income arbitrage can be a complex and risky strategy, and it requires a deep understanding of the bond market and the factors that can affect the prices of fixed income securities.
Options arbitrage is a trading strategy that seeks to profit from differences in the price of options on the same underlying asset.
It involves buying and selling options in such a way as to lock in a risk-free profit.
There are several types of options arbitrage.
One strategy might involve buying a call option and selling a put option on the same underlying stock, with both options having the same strike price and expiration date.
The profit from this trade comes from the difference in the premium paid for the call and the premium received for the put.
This, of course, is not a pure arb situation because there is price risk on the downside in the event the stock falls.
Another types of options arb involves volatility.
This could take the form of selling near-term volatility (often more expensive, but not always) and buying/selling enough shares to delta hedge the position.
Another type of options arbitrage is called statistical arbitrage.
This involves using statistical models to identify mispricings in the options market and then exploiting those mispricings through trades.
Options arbitrage can be a complex and risky strategy, as it requires a thorough understanding of options pricing and the ability to accurately predict market movements.
It is typically used by professional traders and investors, rather than individual retail investors.
20+ Hedge Fund Strategies
Pairs trading is a market-neutral trading strategy that involves finding two securities with a high correlation, taking a long position in one and a short position in the other, and then profiting as the spread between the two narrows.
The idea behind pairs trading is to capture the mispricing of two correlated securities and profit from the mean-reverting behavior of the spread between them.
Here’s an example of how pairs trading might work in practice:
Let’s say there are two companies in the same industry, A and B, and their stocks are highly correlated.
Company A has a price-to-earnings (P/E) ratio of 15, while company B has a P/E ratio of 10. The P/E ratio is a measure of how expensive a stock is relative to its earnings, with a higher ratio indicating a more expensive stock.
In this case, company A’s stock is considered more expensive than company B’s.
A trader who is employing a pairs trading strategy might decide to go long on company B (buy stock in company B) and short on company A (sell stock in company A) if he/she felt this mispricing was genuine and would realize itself out in the market over the long-term.
If the P/E ratio of company A subsequently falls and the P/E ratio of company B rises, the trader will profit from the narrowing spread between the two.
On the other hand, if the P/E ratio of company A rises and the P/E ratio of company B falls, the trader will incur a loss.
Pairs trading is typically used by market-neutral funds, which aim to generate returns regardless of the overall direction of the market.
By taking offsetting positions in two securities, a market-neutral fund can profit from the spread between the two without being exposed to the overall direction of the market.
Market Neutral Fund vs. All Weather Fund
An all-weather fund is a type of risk-parity fund that aims to generate consistent returns across different market conditions by balancing the allocation of capital among various asset classes.
The goal of an all-weather fund is to produce fairly consistent returns in both up and down markets, and these types of funds are considered to be relatively low risk as well.
One key difference between market-neutral funds and all-weather funds is the way in which they achieve their low-risk profile.
Market-neutral funds seek to reduce risk by taking both long and short positions in different securities, while all-weather funds seek to reduce risk by balancing the allocation of capital among various asset classes.
Overall, both market-neutral funds and all-weather funds are designed to be low risk and generate consistent returns regardless of market conditions.
However, they achieve this goal in different ways, with market-neutral funds taking both long and short positions in different securities and all-weather funds balancing the allocation of across various asset classes, countries, and currencies.
FAQs – Market Neutral Fund
What are some market-neutral strategies?
Here are a few examples of market-neutral strategies that funds may use:
- Long-short equity: This is a common market-neutral strategy in which the fund takes long positions in stocks that it expects to outperform the market, and short positions in stocks that it expects to underperform. By balancing these long and short positions, the fund aims to generate returns that are not correlated to the overall market.
- Statistical arbitrage: This involves identifying statistical discrepancies between the prices of two securities or groups of securities and trading them in a way that is mathematically calculated to be market neutral.
- Merger arbitrage: This is a strategy in which the fund takes positions in companies that are involved in merger or acquisition activity, with the aim of profiting from the price discrepancies that can occur during the transaction process.
- Fixed income arbitrage: This is a strategy in which the fund takes positions in fixed income securities and uses financial instruments such as options or futures contracts to hedge the market risk of those positions.
- Options arbitrage: This is a strategy in which the fund buys and sells options contracts in a way that is calculated to be market neutral.
These are just a few examples of market-neutral strategies, and there are many other approaches that funds may use.
What does being market-neutral mean?
Being market-neutral means that a trader is seeking to profit from the relative difference between two securities, rather than from a broad market movement.
This means that the trader’s profits are not dependent on the overall direction of the market, but rather on the relative performance of the two securities being traded.
A market-neutral trader will try to isolate a specific spread between two securities and take a long position in one security and a short position in the other.
The trader’s goal is to profit from the difference between the two securities, regardless of the overall market conditions.
How do market-neutral funds make money?
Market-neutral funds aim to generate returns that are uncorrelated with the broader market.
They do this by taking long positions in some securities and short positions in others in order to balance out the overall market exposure of the portfolio.
The goal is to make money regardless of whether the market is going up or down.
One way that market-neutral funds can make money is by taking advantage of price discrepancies between the long and short positions in their portfolio.
For example, if a market-neutral fund takes a long position in a security that it expects to increase in value and a short position in a security that it expects to decrease in value, it may be able to profit from the difference in performance between the two securities.
Another way that market-neutral funds can make money is through the collection of dividends or interest on the long positions in their portfolio.
Finally, market-neutral funds may also make money through the use of leverage, by borrowing money to increase their investment exposure.
This can potentially magnify returns, but it also increases the risk of losses if the fund’s investment bets do not pan out as expected.
Conclusion – Market Neutral Fund
A market-neutral fund is an investment strategy that aims to generate returns that are not correlated with the overall market.
These funds aim to achieve a net asset value that is not affected by market movements by taking both long and short positions in various securities.
The most common general strategy used by market-neutral funds is to take long positions in perceived undervalued securities and short positions in perceived overvalued securities.
This allows the fund to profit from the anticipated price movements of the underlying securities, regardless of the overall direction of the market.
Another strategy used by market-neutral funds is called pair trading, in which the fund takes both long and short positions in two correlated securities.
For example, the fund may take a long position in one company and a short position in a competitor.
This allows the fund to profit from the anticipated price differential between the two securities, regardless of the overall market conditions.
Market-neutral funds may also employ other strategies such as arbitrage, in which the fund takes advantage of price discrepancies in the same security across different markets, or the use of options and other derivative instruments to hedge risk and generate returns.
Overall, the goal of a market neutral fund is to provide investors with a source of returns that is not correlated with the overall market, which can be useful in diversifying a portfolio and mitigating risk.