Last week, Deutsche Bank released its annual Alternative Investment Survey which is “one of the industry’s largest and longest standing hedge fund investor surveys. This year, 504 global hedge fund investors, representing USD 2.1 trillion in hedge fund assets, share their insights into their current sentiment and allocation plans for 2016”. The hedge fund sector is composed of a variety of strategies such as activists, event-driven, global macro or long/short equity just to name a few. Investors have an important panel of possibilities to choose from. In its survey, Deustche Bank stated that market neutral is the new black. But what are those strategies and why are they the hottest thing right now?
Defining market neutral strategies:
In order to understand the concept of market neutral strategies, we first need to decompose the returns of a traditonal long-only actively-managed portfolio in two components: alpha and beta. Here’s how Investopedia defines them both:
- Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole. Beta is used in the capital asset pricing model (CAPM), a model that calculates the expected return of an asset based on its beta and expected market returns. Also known as « beta coefficient. »
- Alpha, often considered the active return on an investment, gauges the performance of an investment against a market index used as a benchmark, since they are often considered to represent the market’s movement as a whole. The excess returns of a fund relative to the return of a benchmark index is the fund’s alpha.
If alpha and beta are unknown to you, you might want to read the article: What’s the difference between alpha and beta?
Market neutral strategies aim to be completely uncorrelated to the market and to have a reduced sensitivity to market shiftings – that is to provide returns at all times. This is achieved by getting beta as close as possible to zero. It is important to point out, that the risk isn’t eliminated, it is transferred: we choose to minimize beta and increase alpha. The risk lies within the hand of the investments managers. Market neutral strategies have traded a low market risk against a heightened exposure to the stock and bond selection skills of the investments managers.
To decrease beta and increase alpha, investment managers take, at their discretion, both long and short positions.
This approach is driven by pure logic. When conducting a high-quality investment research, the investments managers identify the securities that will underperform as well as the ones that will outperform. Why should an investment manager only exploit his ability to identify the outliers, and follow a long only strategy. By shorting the laggars and longing the top performers, the aim of a market neutral strategy is to roughly equalize the aggregate beta of the long and the short investments, thus minimizing beta.
The difference between the returns of long and short book is the return of a market neutral strategy.
Let’s suppose that our investment manager knows what he’s doing: in the a rising market the gains from the long positions should thus be greater than the losses from the short investments. Similarly, the gains from the short positions should outweigh the losses from the long investments in a declining market.
The challenges of implementing such a strategy:
While the strategy might be quite simply in concept, its implentation can be very complex. Here are two parameters that can make neutrality extremely difficult to achieve: beta and liquidity.
- Having a low beta doesn’t mean that the model is immune to the fluctuations of the broader financial market. This is simply due to the fact that market risk is not perfectly measured by beta and correlation. A conventional indicator of neutrality such as beta doesn’t grasp systematic-like risk that have an effect on the returns such as the country, the sector or the currency of the stocks. (Other indicators could be used such as smart beta). Let’s suppose that we stick with beta: if investments managers either ignore or heavily depend on these systematic-like risk factors, such strategies may have a hard time being neutral in all types of markets. For example, if a market neutral strategy depends heavily on a monetary policy in place such as the quantitative easing in Europe, the strategy might not remain neutral once the quantitative easing comes to an end.
- As we know, not all securities are liquid. History has showed that illiquid stocks usually outperform liquids ones over time. Thus switching the long positions towards illiquid stocks might be tempting. Yet it can have very nefast effects during market stress periods as illiquid securities tend to be the most vulnerable ones during such times.
The misinterpretation of such parameters can be seen as the reason why the market neutral strategies differ from one fund to another. Some managers grasp and manage these systematic-like risks better than others: thus some market strategies are more neutral than others.
The specificities of market neutral strategies:
In seeking to generate investment gains almost exclusively from the performance of individual securities, market neutral strategies have unique specificities. Market neutral strategies’ returns rarely coincide with those of mainstream asset classes. Market neutral and world equities experience high and low peaks at different occurrences. This suggests that the factors responsible for the volatility of market neutral funds are different from those that influence equity markets, which was exactly the aim of these strategies. Considering this particular return pattern, we can affirm that market neutral strategies can indeed diversify risk and return in a large portfolio.
Market neutral strategies are a source of capital stableness and protection from investors, especially during declining markets. By looking at the following chart, we can see that the maximum drawdown encountered by market neutral strategies has been a lot smaller than that of equities. In addition, we can see that it also outperformed fixed income. Market neutral funds have managed to achieve a lower volatility than bonds and stocks while keeping risk-adjusted returns greater than mainstream assets over time.
Why are market neutral strategies the new black?
While the underlying concept of market neutral strategies is not recent, such alternative investments are becoming appealing to a broader public. The reasons are the following:
- Since the end of 2015, the equity market has been quite volatile. Investors have thus identified opportunities on the short side. They expect still more volatility in 2016, and as we’ve seen market neutral funds are a way to avoid market volatility.
- From a macroeconomic point of view, the very lax monetary policies in place have provoked major changes in the investment sector. Monetary policy is one of the systematic-like risks that changes the risk-return profile of mainstream asset classes. Fixed income risk premium and high equity valuation are likely to be an uncertain source of return in the coming years.
In its survey, Deustche Bank affirmed: “ After a strong year of performance, equity market neutral strategies are expected to be amongst the best performers in 2016, and are also the most in-demand. On a net basis, 32% of investors are increasing their exposure to fundamental equity market neutral (versus 17% last year), and 18% to systematic equity market neutral (versus 11% last year).”
- In Summary:
Market neutral strategies may well be the new black, even if it is not widespread right now. Business Insider claims : ”There may be only a few dozen true fundamental equity market neutral funds with $1 billion-plus in assets under management”. However these few dozen of funds are composed of key players in the industry such as Citadel, Blackrock, Bridgewater just to name a few…