Market neutral refers to a type of investment strategy wherein an investor can profit from either an increase or a decrease in stock prices. It is usually done in order to avoid a given type of market risk and may be executed in one or more markets.
A market neutral strategy may typically be achieved by using both long positions in one security and short positions in another security. It increases the return from good stock selection and minimizes the returns made due to broader market movements.
The returns generated are unrelated to market swings and independent from actual price movements in stocks and bonds. One of the most important things to consider while employing market neutrality is specifying the kind of market risk to be mitigated.
Market neutral refers to a type of investment strategy wherein the investor aims to profit from both an increase and a decrease in stock prices.
There is a fundamental difference between long/short equity funds and market neutral strategies, even though they may be conflated quite often.
The two main types of market neutral strategies are fundamental arbitrage and statistical arbitrage.
Difference Between Long/Short Equity Funds and Market Neutral
A fundamental difference between long/short equity funds and market neutral strategies exists, even though they may be conflated quite often. Long/short equity funds focus on taking advantage of undervaluation or overvaluation across several industries by taking varying long and short stock exposures.
The latter, on the other hand, makes concentrated bets in order to hedge out any sort of systematic risk. Thus, their main goal is to achieve a zero beta as opposed to the market index.
Types of Market Neutral Strategies
There are several methods of employing a market neutral strategy. Popular tools used by strategists include merger arbitrage, shorting sectors, etc. The two main types are as follows:
1. Fundamental Arbitrage
In order to project a given company’s share price trajectory and execute profitable trades based on the predictions, the investor used a fundamental analysis instead of quantitative algorithms. Fundamental analysis may include the overall financial health of the business, market conditions, competitors, etc.
2. Statistical Arbitrage
When a manager places trades on stocks based on quantitative methods, they use sophisticated algorithms to analyze historical data and expose price discrepancies in the given data. They then place their bets on stocks that are most likely to revert to their historical mean.
Advantages of Using Market Neutral Strategies
Market neutral funds focus on mitigating market risk while constructing a portfolio. In a situation where financial markets are characterized by high volatility, such funds are more likely to outperform other funds that employ different strategies.
Placing specific bets on convergences of stock prices simultaneously hedges away general market risk, which enables market neutral strategies to achieve low positive correlations with the market.
Example of a Market Neutral Strategy
Hedge funds usually hold market neutral positions, which enables them to exploit any sort of momentum that arises with price movements. Hedge funds prefer to remain market neutral because they desire absolute returns, not relative returns.
For example, they may take a 50% long position and 50% short position in any industry in order to remain market neutral. If the market moves up, the losses due to the short positions are offset by the profit made in the long investments.
What is an Equity Market Neutral (EMN) Strategy?
An equity market neutral (EMN) strategy insures the investor against market exposure. It is possible because its performance is measured according to the spread between the long and short exposure of the fund. The fund manager exploits the price movements by holding both long and short positions in stocks that are closely related.
For example, they may belong to companies in the same market sector, industry, or country. They may also be historically correlated or with similar market capitalization. Portfolios carrying EMNs can create positive returns for the investors regardless of the overall market trend (bullish or bearish).
Stock picking is the most important aspect of a good EMN strategy because the actual market movement becomes irrelevant. This is because, regardless of which direction the sector moves in, the gains and losses made by the trades offset each other.
CFI is the official provider of the Commercial Banking & Credit Analyst (CBCA)™ certification program, designed to transform anyone into a world-class financial analyst. To keep learning and developing your knowledge of financial analysis, we highly recommend the additional CFI resources below:
Take your learning and productivity to the next level with our Premium Templates.
Upgrading to a paid membership gives you access to our extensive collection of plug-and-play Templates designed to power your performance—as well as CFI's full course catalog and accredited Certification Programs.
Already have a Self-Study or Full-Immersion membership? Log in
Access Exclusive Templates
Gain unlimited access to more than 250 productivity Templates, CFI's full course catalog and accredited Certification Programs, hundreds of resources, expert reviews and support, the chance to work with real-world finance and research tools, and more.