© Copyright 2006 Rogers Publishing Ltd. The following article first appeared in the May 2006 edition of BENEFITS CANADA magazine.
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Equity market neutral is an investment strategy that has fallen off the radar screen. But to large pension funds it offers consistent returns and flexibility, regardless of what’s happening in the market.
By Patrick Roy

Among the multitude of alternative investment strategies available to institutional and retail investors, one of the most basic and possibly the purest of all strategies—Equity Market Neutral(EMN)—seems to have been forgotten. An EMN strategy is an investment approach that seeks to exploit differences in stock prices by taking offsetting long and short equity positions within the same sector, geographic region or market capitalization. Long positions involve buying a security with the expectation that the asset will rise in value. Short positions involve the sale of a borrowed security with the expectation the asset will fall in value.

Why the lack of interest? It could be the simplicity of this approach compared to many other alternative strategies. It is designed to deliver consistent returns within a well-defined risk framework, regardless of the financial or economic climate. So, it could be that the bullish environment for equities of the past three years—especially in Canada—has kept EMN strategies off the radar screen of most institutional and retail investors.

But EMN strategies have much to offer plan sponsors as this economic recovery phase enters its fourth year. The reality of lower prospective stock and bond returns will force investors to exploit the greater flexibility and superior risk/return trade-off of market neutral strategies.

This approach is typically characterized by its neutrality to several risk factors, such as beta(measured against the S&P/TSX—appropriate for an EMN strategy that invests primarily in Canadian equities), market capitalization, dollar exposure and sector allocation.

Sophisticated risk management techniques are generally used to hedge the systematic market risks of the portfolio. The more tightly risk is constrained, the more “pure” the approach and the closer one gets to a true stock picking alpha.

Technically, EMN strategies generally employ some form of leverage. For example, a strategy with a maximum of $1 in long positions and $1 in short positions for each $1 investment is considered to have a maximum leverage of 2:1.

EMN strategies are commonly misnamed “long/short strategies.” What is the distinction? Long/short strategies derive their returns from three sources: first, the differences in the returns between longs and shorts—just like EMN; second, the residual beta exposure of the markets(some directional bias in the form of an excess of long or short positions); and finally, often from some leverage. While it is a subtle difference, long/short strategies attempt to add alpha by picking specific stocks on both the long and short sides. In contrast, an EMN strategy is more oriented to a portfolio approach: groups of longs and shorts.

Put simply, alpha is the distillation of the manager’s skill from the underlying performance of the market. It can come from long positions, short positions or both. In practice, there are three profitable scenarios. The first is when long positions rise and outperform rising short positions. The second happens when longs decline but less so than declining shorts. Finally, there’s the best-case scenario: longs rise and shorts decline.

Three attributes must be part of any EMN strategy: style consistency, “pure” equity exposure and no directional bias. Much like any long-only strategy, you should look for style consistency—basically, a manager who outperforms for the same reasons repeatedly. You should avoid managers without a clearly defined process or discipline. Otherwise, the source of alpha will quickly evaporate—as will the attractive returns.

To gain “pure” alpha from equities, you must avoid managers who profess to be stockpickers but do not hedge their currency exposure and/or other economic factors that can impact returns.

Although many managers claim to be market neutral, they often have some market exposure within their portfolios. Quality EMN managers will have sophisticated risk measurement diagnostics that will prove their hedging skills over their performance history. They will also have attribution technology capable of confirming style consistency.

Pure EMN strategies tend to perform exceptionally well as a diversification tool due to their very low correlation with most major asset classes. In fact, a well-designed EMN strategy should have no correlation to traditional asset classes.

EMN strategies can also be useful for pension funds due to the absolute nature of the return pattern. These strategies rely on a portfolio manager’s ability to pick stocks relative to each other in one or several equity markets. What drives potential returns are the manager’s skill and the inefficiency of the markets in which they operate(from this perspective, the Canadian equity market has excellent potential).

EMN investing can be considered an asset class by virtue of its unique return characteristics, weak correlation and low volatility. Typically, the reference are Treasury Bills.

For example, an EMN strategy targeting a return of T-Bills + 5% at a 7% volatility level would compare favourably to short-term fixed income instruments or, in some cases, even broader fixed income mandates.

The mechanics of the portfolio structure provide the money market rate as a base return since T-Bills generally provide the collateral against the securities borrowed in creating the short positions. The cash from the shorts is then used to fund the longs. Within a bearish equity market, such an approach would also be an excellent alternative to cash or a defensive equity stance.

Where EMN strategies really shine is through the vehicle of portable alpha—a concept that many funds and market participants are eager to employ. In this case, instead of building the base return on a T-Bill portfolio, as described above, the long and short equity positions are overlaid on a bond portfolio or even over an equity mandate.

Consider a basic low-risk EMN strategy with 7% volatility and expected alpha of 5%. The EMN alpha is then added to the return of the underlying asset class. The 7% risk of the EMN strategy is reduced significantly when combined with the underlying asset class given the lack of correlation. The information ratio (which measures the consistency with which a manager beats a benchmark)of the combination increases substantially.

Risk levels are tailored in the development of the portable alpha combinations by adjusting the size of the long and short positions relative to the value of the underlying asset class. The 7% volatility in the example could be reduced to 3.5% by simply managing the long and short position at 50% of the value of the underlying asset class.

There is a belief that only “pure” hedge fund managers can be successful with EMN strategies and other long/short mandates. Others believe that traditional and alternative strategies will converge into one approach, allowing managers to offer both types of mandates.

Large money management firms do have several characteristics that can help them in the alternative world. A large asset base means more strategic support functions are available relative to an emerging hedge fund, particularly when it comes to compliance, risk monitoring and a strong equity research infrastructure.

Given the reality of lower prospective stock and bond returns, an EMN strategy is one that plan sponsors should consider. The advantage is the ability to obtain returns that do not depend on the returns of the underlying equity market. There is also increased flexibility in exploiting a portfolio manager’s skill in stock selection, ultimately creating the potential for a superior risk/return trade-off for the entire asset portfolio.

Common Market Neutral Investing Myths

1)Market neutral managers are not successful with short positions. A perfect short position should decline in value or at least underperform the market. However, “shorts” can be successful even if their returns are higher than those of the market, the important aspect being the relative return vs. the corresponding long position.

2)Leverage is required for a market neutral strategy. Leverage is not really relevant. This important attribute is the risk management technology that controls the expected volatility of returns. An EMN strategy with no leverage could display as much risk as a strategy with 2:1 leverage.

3)Market neutral managers must be fully invested. Contrary to the long-only manager who invests capital to replicate a large-cap benchmark, all positions in an EMN strategy represent active risk. For this reason, the contribution of specific risk to total risk is much closer to 100% for an EMN strategy than for a long-only approach.

4)It’s not possible to benchmark an equity market neutral strategy. This is only true if you do not consider T-Bills as a useful benchmark. In fact, the T-Bill benchmark is one of the finest qualities of EMN. This benchmark allows the “pure” alpha to be transported over any traditional benchmark.

Patrick Roy is vice-president and senior portfolio manager, Alternative Equities and Trading Strategies at Fiera YMG Capital in Montreal. proy@fieracapital.ca