What is a market neutral fund?
A market neutral fund is a hedge fund who seeks profit regardless of a bullish or bearish market environment, usually through the use of matched long and short positions or derivatives. These funds can potentially be used to mitigate market risk as they seek to generate positive returns in all market environments.
Key points to remember
- A market neutral fund describes a hedge fund strategy that seeks to achieve above average returns regardless of market conditions.
- Being market neutral, the fund takes offsetting long and short positions so that it has a zero delta or zero beta position and is independent of upward or downward price movements.
- While market neutral funds can generate alpha, these strategies tend to be complex and highly leveraged, which increases both risk and costs for investors.
Understanding Market Neutral Funds
Market neutral funds are designed to provide returns that are unrelated to those of the overall stock market. In financial terminology, market neutral funds are designed to provide alphabut little or none beta. Beta is the correlation of an investment with a broad stock market index such as the S&P500and alpha is the additional return beyond the market return obtained through active trading.
However, this does not necessarily mean that a market neutral fund will beat the market or that an investor would benefit from having a market neutral fund in their portfolio. Adding these funds to an investor’s portfolio has the potential to increase returns and reduce risk, but these funds are much more complex than traditional funds. mutual fundand expenses can be high.
Market neutral funds can be high risk since their investment strategies rely on the use of leverage, short selling and arbitration to achieve the desired results. Expected returns can vary widely for these funds depending on the tactics deployed. They are often seen as a potential option for mitigating risk in downtrend markets, as they generally offer higher yields than money market holdings. However, some fund managers have historically had more success earning returns from benchmarks such as the S&P 500.
Market neutral fund strategies
Market neutral fund strategies simultaneously take long and short positions; however, they are distinctly different from long/short fund. Market neutral funds typically use arbitrage strategies that take advantage of matched trading positions. These funds can generally use either a qualitative approach or a statistical correlation approach. They aim to be neutral market and generally focus on equities due to the transactional opportunities available.
Market-neutral strategies tend to generate profits that are uncorrelated to market movements, meaning that their profits are generated primarily based on the price movements of the stocks concerned. There are several variations of market neutral funds, with equity market neutral (EMN), for example, specialized only in equity trading.
Qualitative strategies involve paired trades between two securities or market products identified by the portfolio manager as having arbitrage potential convergence opportunity. Statistical correlation strategies involve matched trades that specifically exploit deviations from a historically high correlation for convergence arbitrage. These strategies use long and short pairs to achieve capital gains.
Pair trading requires closely monitored technical analysis. After identifying securities with market-neutral arbitrage profit potential, investors look to take timely long and short positions that should benefit from price convergence.
In the case of statistics correlation trading pairs, an investor will first identify two highly correlated stocks. Correlations of 0.80 or greater are generally the most prevalent. By following the correlations of stock pairs through technical analysis, an investor will then look to go long in the underperforming stock and short in the outperforming stock when the correlation deviates from its historical norm. Trading the pairs is looking to take advantage of the correlation correction which should return to its historic level of 0.80 or higher. If successful, price convergence results in gains in both the long position and the short position.
Invest in market neutral funds
Market-neutral strategies are most often available from hedge fund managers, who may offer the management style in a hedge fund structure or a registered product structure. Since market neutral funds are quite complex products with high risks, they are not suitable for all types of investors and are generally not used as core holdings. These funds also tend to have fairly high fees as well as turnoverwhich may be investor considerations.
Example: AQR Equity Market Neutral Fund
AQR is a family of hedge funds that provides an example with its Market Neutral Equity Fund. The Fund’s benchmark is the Bank of America Merrill Lynch 3 Month Treasury Bill Index. It uses qualitative and quantitative analysis to identify opportunities for trading conditionally attractive pairs. In 2022, the Fund generated a 1-year return of 22.08% compared to -2.23% for the 5-year return. The Fund has a management fee of 1.10% with gross expenses of 1.81%.
Example: Vanguard Market Neutral Investor Fund
Because it is a market-neutral strategy, the Vanguard Market Neutral Fund Investor Shares fund uses long and short put strategies, unlike the company’s other mutual funds, which only buy and sell. only sell long positions. The fund’s strategy aims to minimize the impact of the stock market on its returns, which means that the fund’s returns can be very different from those of the market.
Although most funds that sell stocks short, such as hedge funds, do not disclose their short holdings because SEC rules do not require them to do so, Vanguard Market Neutral Investor Shares publishes its shorts. He chooses short positions by evaluating companies in five categories: growth, quality, management decisions, sentiment and valuation. Then it creates a composite expected return for all the stocks in its universe and shorts those with the lowest scores.
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