After an eight-year equity bull market, investors might have forgotten about market neutral strategies. However, many commentators are pointing to equities as being fully priced and some fear a correction. Should institutional investors seriously consider increasing their allocations to the market neutral space?
Equity market neutral (EMN) arguably began in 1949 with a vehicle started by Alfred Winslow Jones widely dubbed the first hedge fund, which took long and short positions in equities.
Today, some of the world’s largest and longest established hedge fund managers run EMN strategies that have moved on enormously since then, thanks to advances in academic finance, data and technology. The strategy has also become much more accessible.
Systematic and discretionary
EMN can be split into ‘systematic’ and ‘discretionary’. The former can itself be subdivided into two broad categories, Statistical Arbitrage (stat arb) and Fundamental Analysis.
Stat arb approaches use technical inputs, which are mainly historical price data. Traditionally, stat arb was based on mean reversion models but these are among many forms using pattern recognition. The most modern types of statistical analysis can include machine learning technology and non-fundamental scoring.
Fundamental or factor-based approaches mainly use fundamental data such as accounting and economic data but can also use price data for factors such as momentum.
Discretionary EMN can also be split in two categories, with a Fundamental and a Multi-strategy approach. A fundamental value approach would involve pairs trading. A Multi-strategy approach can include event-driven trades. Multi strategy can also be a very broad label that includes hybrid approaches, blending systematic and discretionary inputs.
All EMN approaches have substantially less equity market exposure than long-only funds; aim to generate most or all of their returns from alpha rather than beta; and have some short exposure to equities, via one or more of single stocks, sectors or indices.
Who should consider EMN?
After an eight-year bull market in global equities, some investors might have forgotten about EMN strategies but many institutions are actively allocating to them. A survey in 2016 found that 32% wanted to increase their allocations to equity market neutral strategies.1
Where do EMN strategies fit into portfolios? EMN funds should have little or no directional exposure to the equity market, although this is not always true in practice. Their low volatility and low equity market correlation should therefore reduce volatility and drawdowns for portfolios exposed to equity markets. As such, EMN is a complement for equity long-only or long-biased equity long/short exposure.
EMN generates a better diversification benefit than long/short or hedge funds in general. This is because indices of EMN strategies have nearly always shown lower correlations to equity markets than have indices of equity long/short strategies.
A bond substitute?
Yet many EMN strategies have a level of volatility and returns more typically associated with fixed income investments. Most EMN indices have shown volatility 1% either side of the JP Morgan Government bond index, whereas long-only equities have exhibited volatility roughly five times as high as bonds.
In a climate of low or zero interest rates, returns come mainly from the spreads between long and short book performance, minus fund fees and costs. The lack of reliance on market direction means market neutral strategies can potentially perform in an equity bull market, bear market, or in a range-bound sideways market. When and if interest rates normalize, the interest on excess cash (minus fund fees and costs) could also make a significant contribution to returns.
A cash-plus strategy
Moreover, EMN is a cash-efficient strategy that benefits from rate rises. Since the long books of EMN strategies are substantially financed by the proceeds of short sales, they are sitting on excess cash that can be up to 85% of NAV and should earn some interest rate yield. Therefore, EMN is to some extent a “cash-plus” strategy, earning interest on cash, plus or minus the alpha generated from stock selection.
The largest risk factors for EMN tend to be idiosyncratic, stock-specific or factor risks. More specifically, the risk is negative alpha from a long book that underperforms the short book. On the short book, there is an additional risk of stock loans being recalled or repriced upwards. Borrowing securities also entails counterparty risk.
Where portfolio construction is predicated upon historical or forecast patterns of correlation between securities, sectors, markets, and regions, unexpected patterns of correlation can lead portfolio risk to over or undershoot targets and may cause losses.
Many institutions need to reduce equity exposure. They may have a mature liability profile; solvency and capital adequacy rules may penalize long only equity exposure; and some pension funds even face negative cash flows in net terms. Unconstrained allocators might also want to reduce equity exposure if they perceive equities to be highly valued.
Ultimately, calling a market peak is a fool’s errand but allocators should consider rebalancing portfolios incrementally, reducing exposure to more richly valued asset classes and increasing exposure to less richly valued ones.
1Source: The Deutsche Bank Alternative Investment Survey, which surveyed 504 investors representing $2.1trn of assets
Manfred Schraepler (above left) is head Financial Assets & Liquid Private Markets, Aquila Capital and Christian Humlach, Client Advisory Financial Assets