What is market neutral trading?

Market neutral trading or investing is a portfolio management strategy that aims to reduce the risk of a portfolio to fluctuations in asset prices in the market of a specific asset class while achieving positive returns in the portfolio as a whole. In the stock market this is usually achieved by constructing long-short portfolios by taking long positions in some stocks and short positions in others so that the correlation of the portfolio’s returns to the return of a particular stock index such as the S&P 500 is close to zero.

Example: Pairs Trading

Pairs trading is a simple example of market neutral trading. Suppose that a trader would like to take a position in the telecom sector but would like to reduce her exposure to the overall performance of the sector because most of the stocks in the sector tend to trade together based on the idea that all of the underlying companies have exposure to the earnings growth and performance of the telecom industry. One way to achieve this would be to place a bet on the relative performance of a pair of stocks in the industry such as Verizon (VZ) and AT&T (T).

Suppose that our trader expects AT&T to outperform Verizon. She could have many reasons for making this prediction. For example, she may believe that AT&T will take market share away from Verizon because iPhones are only available on AT&T’s service and she expects many Verizon subscribers to switch to AT&T so they can use their iPhones.  In this case she would take a long position in AT&T and a short position in Verizon. This pairs trade is not a riskless a position, however, far from it, but it does enable her to reduce her exposure to the aggregate performance of the telecom sector.

The risk in this position lies in the relative performance of AT&T versus Verizon. If she were to place half her money in her long AT&T position and the other half in her short Verizon position, then if AT&T outperforms Verizon, she will make money, but if Verizon winds up outperforming AT&T, then she will lose money. However, she could place different portions of her capital in each position.

Zero Beta Risk Management

A common method of risk management for market neutral portfolios is called zero beta risk management. The goal of zero beta risk management is to try and completely eliminate a portfolio’s risk with respect to the performance of a particular group of assets. In this case our investor would like to eliminate her risk with respect to the aggregate performance of the telecom sector. She can accomplish this by weighting her long and short positions such that the beta of her portfolio relative to the performance of the telecom sector is zero.

Here we speak of the beta from the Capital Assets pricing model (CAPM), which is calculated by performing a linear regression. I will not go through the details of this computation in this article, but if you are unfamiliar with CAPM, you can read about it at many places on the web, and a great place to start is the Wikipedia article (http://en.wikipedia.org/wiki/Capital_asset_pricing_model).

An equally dollar weighted portfolio generally does not have zero correlation to the underlying index. This is because the components of the index generally do not have the same volatilities. For example, Verizon has historically been a bit more volatile than AT&T. Thus, if the telecom sector rises sharply she is likely to lose money in an equally weighted portfolio because Verizon will rise more than AT&T because Verizon trades in a more volatile fashion.

To solve this problem she can compute the beta of each stock with respect to a telecom sector index such as the Dow Jones US Telecom Index. She will then choose the weights for each position by looking at the relative size of the betas for each stock. For example, if Verizon has a beta of 1.2 with respect to the telecom index while AT&T has a beta of 0.8, then she would place 60% of her capital in her long AT&T position and 40% of her capital in her short Verizon position. This follows from solving the set of simultaneous equations below:

WT + WVZ = 1

WTβT + WVZ βVZ = 0

where WT, WVZ, βT, βVZ are the weights for AT&T and Verizon and their corresponding betas, respectively.

This analysis can be extended to more complex portfolios consisting of more than two stocks. One important thing to consider, however, is that the betas used in this analysis are usually the historical values for the beta and not the future values. The beta of a stock is not a static value but rather, dynamic just as the stock’s price and can change wildly over time. Thus, this analysis leaves one with the problem of predicting the future values of beta. Using the historical value of beta is often a great place to start, but there is no guarantee the future beta will be close to the historical value.

Market Neutral Portfolios

A portfolio is referred to as “market neutral” with respect to an index if its beta is zero with respect to that index and such portfolios are called market neutral portfolios. Market neutral portfolios are not without risk, but they aim to eliminate risk with respect to a certain market, which in our example, is the portfolio’s risk with respect to the performance of the telecom sector as a whole.

In the hedge fund industry there is an entire group of strategies and funds that fall under the market neutral category, each of which aims to reduce risk. Pairs trading individual stocks, long short sector rotation, long short countries, and merger risk arbitrage are common examples. While not all of these funds use zero beta risk management, research indicates that they have the lowest beta of all of the major groups of hedge funds except for short funds which have a negative beta.

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