How does an equity market neutral technique work?
Dampen risk while preserving returns
The market-neutral technique aims to pursue positive returns no matter what happens to the economy, interest rates or financial markets. It can be a welcome and diverse addition to your portfolio as its composition can include range of securities from stocks to index ETFs, CFDs and futures.
Together with the long/short approach, in 1949, hedge fund manager Alfred Winslow Jones applied the first market-neutral strategy after he popularised short selling to profit from declining stock prices. Jones' propagated the idea that portfolios holding both long and short positions could yield positive results regardless of the markets' direction.
The strategy's main objective generate consistent positive returns that are independent from market fluctuations and are influenced by your skill as a portfolio manager.
By being market-neutral, the approach's beta (measure of the volatility or systematic risk) is kept close to zero by containing both long and short portfolios of equal size.
Your long portfolio includes securities you deem attractive or undervalued which you expect to appreciate in value over time, which means the portfolio realises positive returns in such an event.
Your short portfolio includes securities you consider as unattractive or overvalued which you expect to decline in value over time, which means the portfolio realises positive returns that event too.
Implementing the Approach
To implement a market-neutral position, you must invest equal amounts of money into both long and short positions in order to cancel out the impact of market fluctuations.
In declining markets, returns would be positive if long positions fall less than short positions. The difference in the return is based on the performance of the long positions compared to the short positions, known as the 'spread', which occurs because your long portfolio holds different securities than your short portfolio.
The portfolio construction of a market-neutral stocks strategy can be based on differing categories such as market-cap where the long portfolio would hold small-cap stocks and the short portfolio would hold large-cap stocks. You can also construct a portfolio in which you are long stocks but short index or commodity ETFs, CFDs or stock futures.
Your main goal is for the spread to deliver a positive return which occurs when the long positions outperform the short positions regardless of market conditions. If your spread delivers positive returns, the value of the market neutral strategy increases. Conversely, when the spread delivers negative returns, the value of the market neutral strategy declines.
The biggest risk involved with this strategy depends on your skills in picking individual assets to trade and their relevant exposures, be they sectors, industries, cap size, valuations or geographic regions.
Your success then depends on selecting long positions likely to appreciate more rapidly in rising markets and short positions likely to decline faster in falling markets.
As such, a market-neutral strategy relies heavily on a quantitative investment research approach combined with comprehensive trading insights into your long and short selections. As with any forms of investment, a market-neutral strategy still involves risks albeit comparatively less risky than other investment strategies.
By implementing long and short positions in a range of securities such as index ETFs, CFDs and futures, your losses can exceed your deposit. Moreover, if you are including CFDs in your portfolio, your CFD provider will charge you holding fees on the number of CFDs you've included in your portfolio.
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