Controlling Volatility through Market Neutral Investing
Newcomers to share market investing can be surprised to learn there are more ways to turning a profit on a stock trade than taking a long position and waiting for the price to go up or by taking a short position and waiting for the price to go down.
Market neutral investing is rooted in an investing strategy dating back centuries – arbitrage. At its core arbitrage involves identifying price differences in two similar assets. Prior to their entry into stock market investing, profit seeking individuals spotting the difference in the price of a commodity in different markets would buy in the lower market and sell in the higher market.
Today’s market neutral investing copies the essence of arbitrage but with similar assets in the same market. Market neutral investing is best seen today in hedge funds that build portfolios of “paired” assets with observable price discrepancies and opening a long position on the undervalued member of the pair and a short position on the overvalued member of the pair.
This balancing act is designed to build portfolios with a beta value of net zero. Beta is a measure of a stock’s volatility in relation to the market. A beta value of 1.0 indicates the stock follows the market, while betas over 1.0 means the stock is more volatile and betas under 1.0 means the stock price is less susceptible to market volatility.
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High beta stocks are sought by investors willing to assume greater risk for higher rewards, with the opposite for risk averse investors.
A 0 beta suggests a stock pairing is independent of market volatility, essentially making the stock “market neutral.”
How Does a Market Neutral Investment Strategy Work
The long and short positions in a market neutral investment strategy act as a hedge to one another. The net zero beta goal makes market neutral investing decidedly different from a hedge fund taking long and short positions without balancing.
The core of the strategy is to eliminate or minimize systematic risk, with the profits of one position balancing the loss in the counter position,.
Market Neutral funds rely on two methods to spot targeted pairs – fundamental arbitrage and systematic arbitrage, and both in some cases.
As is name implies, fundamental arbitrage attempts to gauge a stock’s price movement based on fundamental aspects of the business, like financial health, economic and sector conditions, competitors, and management quality. If the analysis spots a stock trading below the intrinsic value uncovered by the analysis, a neutral market fund would take a long position on the stock and a short position on a similar stock.
Statistical arbitrage relies on algorithms and quantitative analysis of historical data to spot price discrepancies when compared to a similar stock. Price convergence is the outcome spurring investing in a paired relationship. If the two stocks have historically moved together in the same direction but one is now underperforming the other, the market neutral fund will take a long position on the underperformer and a short position on the overperformer, betting the prices will converge.
As an example, consider two of the most well-known technology stocks in the US – Microsoft and Alphabet (Google).
The two stocks have a history of moving in tandem but the market neutral fund’s analysis has uncovered a discrepancy with the firm convinced Alphabet is currently undervalued while Microsoft is overvalued.
The fund takes a long position on Alphabet and a short position on Microsoft,. The amount invested uses the beta history of the two to achieve a beta near zero.
There are three potential outcomes of this trade, with only one resulting in a loss – if Alphabet shares decline and Microsoft’s share price rises.
The best outcome is for both stocks to perform as the trade specified – Microsoft shares fall while Alphabet’s share price rises, resulting in a profit from both the long and short positions.
The third outcome happens when one of the pair members goes the opposite direction – Alphabet shares go up but so do Microsoft’s with the profits of the correct trade offsetting the losing trade.
The Benefits of Market Neutral Funds
The returns from a paired trade in a market neutral fund do not depend on the performance of the market. In both bull and bear markets, the returns depend on the performance of the paired stocks in relation to each other.
The profit potential independent of market direction is arguably the key benefit of market neutral funds, in addition to the lower market risk. Market neutral funds offer diversification and more stable performance.
Using both fundamental and statistical arbitrage allows a market neutral fund the flexibility to identify and adapt to market opportunities under different conditions.
The vast majority of retail investors lack the resources to use fundament and statistical arbitrage. It is possible to secure the services of a professional financial manager to assist in constructing a market neutral portfolio.
There are managed market neutral funds available, but many target high net worth individuals with their minimum investments. The BlackRock Australian Equity Market Neutral managed fund has a minimum investment requirement of $500,000.
The Bennelong Market Neutral Fund has a minimum investment of $25,000 while the Arrow Market Neutral Fund has a minimum investment of $50,000.
There are ASX listed ETFs (exchange traded funds) that employ risk management strategies, although none classify as market neutral funds.
The VanEck Vectors Australian Equal Weight ETF (MVW) assigns equal weight to all its holdings to reduce market volatility.
The BetaShares Managed Risk Australian Share Fund (AUST) uses a risk management strategy to minimize market volatility.
The iShares Edge MSCI Australia Minimum Volatility ETF (MVOL) targets stocks with lower volatility characteristics.
All three use a variety of risk management strategies including inverse exposure, leverage, and volatility reduction.
Professional investment managers at some hedge funds and managed mutual funds take advantage of increasing and decreasing prices in financial markets. The most common strategy is using sophisticated analysis – both fundamental and statistical – to identify asset pairs with a history of moving in the same direction at the same time. When the analysis finds a pair – most often equities – in divergence, the fund takes a long position on the stock dropping in price and a short position on the stock rising in price.
The assumption is the stock prices will converge in time, leaving the fund with profit on one leg of the trade to cover the loss on the other. When both members of the pair stay or increase their divergence, the fund profits on both the long and short positions. The pairing works on the relationship between the pair members, severing the traditional relationship with the market conditions as a whole.
