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Textbook definition of Market Neutral
Here's how Wikipedia defines an equity market neutral strategy : "Equity-market-neutral is a hedge fund strategy that seeks to exploit investment opportunities unique to some specific group of stocks while maintaining a neutral exposure to broad groups of stocks defined, for example, by sector, industry, market capitalization, country, or region."
Let's understand this with an example
Good definition - but we can perhaps understand this better by looking at an example. We had in a previous Jargon Buster article, discussed alpha and beta in mutual funds (Click Here). Going further from there, we can simply say that a market neutral strategy is nothing but an attempt to get alpha, without any beta getting tagged on in the process. How can this work? How can you get alpha - the excess return over market - without getting the market return - which is beta? How can you ask for the icing without the cake? Surely, the icing has to be placed on top of a cake, isn't it? And, why would you not want the beta but only take the alpha? When would you want to shun the cake and take only the icing?
Let's say that having studied the IT sector very closely, you are convinced that TCS and HCL Technologies will do much better than Infosys and Wipro in the coming years. You consequently expect the former two companies to deliver much better stock price performance than the latter two, over the next 1 year.
You can always invest in TCS and HCL Technologies and hope to make money. But there's a catch - suppose you are not sure of the direction of the market over the next year. Suppose you believe that the market can perhaps go down rather than up due to say political uncertainty, looming elections or any such reason that may be unrelated to IT companies. On the other hand, it could go up as well, since all the negatives are perhaps in the price and macro numbers look like improving slowly. Now what? You are unsure of the direction of the market, but you are certain that in any market conditions, TCS and HCL Technologies will outperform Infosys and Wipro (these are just by way of examples, we are not suggesting that this may be the case). That means that if markets turn bullish over the next 1 year, your call is that TCS and HCL Tech will move up faster than Infosys and Wipro, and if markets turn bearish, TCS and HCL Tech will fall less than Infosys and Wipro.
What you really want to do is find a way in which you can invest for the relative alpha you expect from TCS and HCL Tech, without having to take the beta as well -which is the overall market direction. This is where a market neutral strategy comes into play. You can choose to go long on TCS and HCL Tech and for an equivalent amount, go short on Infosys and Wipro. You can do this through the F&O segment on the exchanges. By going long on two stocks to the extent of say Rs. 500,000 and short on two other stocks to the same extent, you are market neutral as well as sector neutral. Your long positions equal the short positions - and therefore, whether markets go up or down, half your portfolio will be in the money and the other half will be out of money. However, if your call on relative performance (your alpha call) is correct, here's what will happen :
- If the market were to go up, TCS and HCL Tech will go up faster than Infosys and Wipro. The gains you make on your long positions will therefore be higher than the losses on your short positions. The difference will be the alpha that you derived, without having to take any beta (market returns)
- If the market falls, TCS and HCL Tech will fall less than Infosys and Wipro. In this case, the profit on shorting Infosys and Wipro will be larger than the loss on going long in TCS and HCL Tech. Here again, you come out on top, having extracted the pure alpha from your call, while avoiding the beta.
In both cases, what you have really done is to exploit the difference in relative performance of two sets of stocks, without taking a call on the IT sector or the market. This is the essence of what a market neutral strategy is. Or, to be more correct, this is the essence of the long-short strategy, which is one of the biggest streams within market neutral strategies.
Market neutral is at the core of the hedge fund industry
Market neutral strategies lie at the heart of hedge fund strategies, which aim to provide absolute positive returns, irrespective of the direction of the market. Hedge funds have over the last decade become a large segment of the managed funds business particularly in the US, ever since their 18 year secular bull market ended in 2000 and was then followed by the market moving largely sideways in a wide trading band. Since the beta from the market could no longer be taken for granted, the quest for absolute return strategies - which would make money whether markets went up or down, increased exponentially.
There's more to market neutral than long/short
Some of the other market neutral strategies that such hedge funds employ include :
Convertible securities arbitrage : If there is a convertible bond of a company that's effectively trading at a discount to the underlying share, you can buy the convertible bond and sell the share (and arrange for delivery through stock lending mechanisms) and thus lock in the differential as your profit.
Futures / Index arbitrage : If fund managers find mispricing between the futures contracts of market indices and the stock prices of the constituents of the index, they can buy the futures contracts, short the underlying stocks and make a profit without having to take a call on the direction of the market.
While the above two examples are mispricing opportunities, they often don't become mainstream products as it is difficult to have confidence that you will always find enough mispricing arbitrage opportunities in the market, to deploy the money you raise from selling this concept to investors. However, equity long-short - or the quest for pure alpha - without taking a call on the direction of the market, has turned out to be quite a large business internationally.
130/30 funds
A popular variant to a purely market neutral equity long / short strategy is the 130/30 equity fund. In a 130/30 fund, the fund manager owns say 100 rupees of equities as a traditional long only holding and then "spices it up" with a further 30 as a long position through futures and options in some high conviction stocks and also another 30 as short positions in stocks he is very sure will head down. For example, if a fund manager is very convinced that FMCG stocks will now go down and that infrastructure stocks should now start going up, he can, in addition to casting his portfolio of 100 rupees according to this view, take a further 30 rupees of forward long positions in infra stocks and short 30 rupees worth of the most expensive FMCG stocks. The fund manager now has 160 rupees that are trying to achieve alpha for 100 rupees that the investor invested in the fund. If the calls go right, there is a lot more additional alpha that the fund generates, than what it could have under a traditional long only equity fund. The flip side can equally play out - which is that the fund loses more money than most other long only equity funds, because his call on buy infra and sell FMCG did not work out in the market place.
This is of course not market neutral, as 100 rupees are invested hoping that the market will go up. Its only the 30 rupees on either side, totalling to 60 rupees of bets, which are market neutral within themselves.
Alpha portability
The most interesting use of market neutral strategies is when you take advantage of the concept of "alpha portability". If you were able to carry the alpha from a market neutral strategy and "port it" or transfer it into an underlying fund that is for example a low duration accrual based bond fund, you then have an opportunity to "spice up" the returns from this low-risk bond fund, with the alpha that comes from your market neutral strategies. You would, in such a case, invest the bulk of the money into bonds and a small portion would go towards margin requirements for the long and short positions that you take for your market neutral strategy.
The Indian context
This is fundamentally different from the Capital Protection Oriented Funds that we see in our market, as these funds are effectively betting on the direction of the market, with the small portion of the money that is invested either in stocks or deployed in margins for the forward contracts purchased. If markets go down, that part of the portfolio does not perform and consequently, overall fund returns can get muted. If however, a market neutral strategy were to be deployed, the fund manager would not be betting on the direction of the market - rather, he would be betting on his ability to deliver pure alpha.
For this to happen however, the regulator will need to allow "naked short selling" by fund managers - which is not presently allowed. Fund managers are allowed to short only as a hedge - ie they must have an underlying holding of the stock which they want to short, and they would in such a case short a stock only as a hedge against a temporary correction that they perhaps foresee.
To conclude
Market neutral strategies are complex, and perhaps not best suited for retail investors and inexperienced investors. They become relevant when you question the beta of a market but not your own alpha generating abilities. When market players believe that markets will be directionless or are likely to trade in a range for several years, or that volatility and unpredictability will keep increasing, that's when they would want to cut out beta and try and focus on pure alpha - which is where their skills are supposed to lie. That's when market neutral strategies can best be employed.
In the Indian context, market neutral strategies can be deployed by portfolio managers for HNI clients, based on whether they see merit in such a strategy for their clients' circumstances. Porting alpha from a market neutral strategy onto a low risk bonds only portfolio is also an alternative that domestic portfolio managers consider and use, when appropriate.
However, for the vast majority of us in the market who are hoping for a secular equity bull market to take shape, beta is perhaps just as important, if not more, than just the pure alpha!
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