What it means
A market neutral manager buys securities they expect to do well (long positions) and sells short securities they expect to do badly. Short selling means borrowing a security and selling it, hoping to buy it back cheaper later.
The two sides are sized so that a rise or fall in the whole market has close to no net effect on the portfolio. The return then comes from the gap between winners and losers.
If the long holdings rise more than the short holdings, or fall less, the portfolio makes money whatever the market does. This is why the strategy is described as seeking absolute returns, meaning returns not tied to a market index.
There are different ways to be neutral. Dollar neutral means the value of the longs equals the value of the shorts.
Beta neutral means the sensitivity to market moves is balanced, which can require holding unequal dollar amounts because some securities move more than the market. The strategy is not risk free.
Costs include borrowing fees on shorted securities, trading costs and the manager's fees, and returns are often modest. The portfolio also faces the risk that the manager's stock selection is wrong, or that lots of funds are in the same trades and unwind them together.
Businesses meet the idea in hedge funds, pension fund allocations and treasury discussions about reducing exposure to market swings. The practical test is whether a portfolio's returns have a low correlation with the broad market over time.
In practice
Real-world examples
Example 1
A hedge fund buys the two retailers it considers best managed and shorts the two it considers weakest. Sector exposure is balanced, so a general fall in retail shares affects both sides. The fund profits if its judgement about relative quality is right.
Example 2
A pension fund allocates 10% of its assets to a market neutral manager in order to diversify away from its large holdings of shares and bonds. The finance team expects returns that do not rise and fall with the stock market. It monitors correlation with its other holdings every quarter.
Example 3
A corporate treasurer with a large holding of the company's own shares considers a hedging programme that shorts a basket of similar shares. This reduces the exposure to a general market fall, though it does not protect against a fall in the company alone.
Think of it
Imagine a seesaw where you bet on which child will climb higher relative to the other, rather than betting on whether the whole playground will float up into the sky.
Formula
Calculation
Net beta exposure = (Long value x Long beta) - (Short value x Short beta)
Suppose a fund holds $10,000,000 of long positions with an average beta of 1.2 and wants to be beta neutral by shorting stocks with an average beta of 1.0. The beta-adjusted long exposure = 10,000,000 x 1.2 = $12,000,000. To offset it, the fund needs a short value of 12,000,000 / 1.0 = $12,000,000. Net beta exposure = 12,000,000 - 12,000,000 = $0. A dollar-neutral portfolio with only $10,000,000 short would leave 12,000,000 - 10,000,000 = $2,000,000 of net market exposure.Case study
Seen in the real world
Tidewater Partners is an illustrative, fictional investment firm that launched a market neutral fund with $50,000,000 of capital, holding $50,000,000 of longs and $50,000,000 of shorts. In its first year, the stock market fell 12%. The long holdings fell 8% and the short holdings fell 14%.
The long side lost 50,000,000 x 0.08 = $4,000,000, while the short side gained 50,000,000 x 0.14 = $7,000,000. Before fees and costs, the fund made $3,000,000 in a year when the market lost money.
The illustrative lesson is that the fund made money from the 6 percentage point gap between its longs and its shorts, not from the market. The managers also noted that in a rising market the same structure would have produced modest gains, and that fees and borrowing costs would take a portion of either.
Watch out
Common mistakes
- Assuming market neutral means risk free, when the manager's stock choices, borrowing costs and crowded trades can all cause losses.
- Equating dollar neutral with beta neutral, when equal dollar amounts can still leave net market exposure.
- Expecting high returns, when the strategy is designed for steadier, lower returns that do not depend on market direction.
Questions
People also ask
Is market neutral the same as a hedge fund?
No, a hedge fund is a type of investment vehicle, and market neutral is one strategy that some hedge funds, and some other funds, use.
How do you check whether a fund is truly market neutral?
Look at its beta and its correlation with the broad market over time, since a genuinely neutral fund should show values close to zero.
Why do some market neutral funds lose money in market crises?
Because many funds hold similar trades, and forced selling by one group can move prices against the others, even when the overall market exposure is balanced.