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b <b519b@xxxxxxxxx> wrote:
Has any one here actually used a market neutral approach
with success?
I have been curious about market neutral investing/trading
for sometime, but my outlook is darkened by a paragraph
from a user review of Joseph Nicholas's Market Neutral
Investing. The user says the book is a very good but the
approach itself is not.
Here is a quotation (the full review can be found on
Amazon):
"I am skeptical about the superior risk adjusted return of
market neutral strategies because of my own experience. We
invested in three such market neutral funds. They had
alluring past performance that confirmed everything
Nicholas says about such funds. The minute we invested in
such funds, their performance mysteriously deteriorated.
Somehow, all these funds benefited from convergence before
we invested. But, suffered from divergence right after we
invested. Within two years, we closed out
our investment
positions in all three funds, and never regretted it....
Besides my reservation regarding market neutral investing,
this book gives you an excellent foundation on this
subject."
--- Pal Anand <palsanand@xxxxxxxxx> wrote:
>
> The reader reviews of this book were not encouraging.
>
> rgds, Pal
>
> > If you liked the above article on pair trading you
> would
> like "Market Neutral" ( Long /Short strategies for Every
> Market
> Enviroment) by Lederman and Kleine which has a lot of
> such similiar
> strategies and given in detail including the above
> .Scraps of the
> book can be found by any search engine and are available
> all over the
> web.
> >
> >
> > Warm regards,
>
> Natasha
$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$
Hi,
Regarding the mails above,market neutral investing is a series of strategy used by most if not all hedge funds and is as old as the hills.It is also used by individual investors especially high net worth (HNI)who are mostly seasonal investors.We use amibroker viz charting software to make our trading decisions but these guys use the charts as an additional and not a primary decision making tool.Basically it is used to make portfolio beta neutral(zero).It is used to trade various other instruments also.
The book you have mentioned (Nicholas) is one of 4 available on amazon and the only one with reviews.Nicholas is very well informed about the market neutral outlook but he is basically a consultant on hedge funds.The reviews of his book are not bad and the book appears to be a basic book of info according to one review.The authors (Lederman and Kleine)have more than 20 books under their belt and are in the primary business of trading and writing about diverse aspects of trading .Frankly i like their books and belive in most of the things they write.(Make sense to me).
Personally i would read a book written by a renowned person whose primary business is writting about trading strategies and trading instruments and read about all aspects of market neutral before picking a hedge fund to invest in .It is not just one strategy.
I have selectively enclosed a page out of the many i have in my digital library because it has a ref to a nobel laurete and his paper on the subject.
There is also some info from a chapter of the book at www.sandalwoodsecurities.com/chpfundoffund.pdf
Its not difficult to write a book.All you need is above average information on the subject which is easily available after some research, excellent command of the language and mostly proper presentation.I have downloaded a truckload of info from the web about all aspects of trading . I can write a book and my friends can give reviews.
I am currently a seasonal investor Btw and trying to get to know how the other side invests using charts etc, etc,
Happy reading.
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<DIV class=CS_Textblock_Text><SPAN class=JorGenPgHeader>Market
Neutral Investing<BR><SPAN class=JorGenPgText>by Mark T.
Finn</SPAN><BR></SPAN> </DIV></SPAN></SPAN></DIV></SPAN><FONT
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<DIV class=CS_Textblock_Text>For those investors who believe
in active management, a market neutral strategy may offer the
most attractive asset allocation option available. While
market neutral strategies have not been widely used to date,
there are signs that the trend may be changing. These signs
include recent articles in the popular press, such as
<EM>Business Week, U.S. News & World Report, Forbes</EM>
and <EM>The Wall Street Journal</EM>. In addition, several new
market neutral mutual funds have become available and more are
expected. (A change in tax regulations in 1997 lifted certain
restrictions on short selling, thereby making a market neutral
mutual fund possible for the first time.) In addition, there
seems to be a significant increase in interest in market
neutral strategies from institutional plan sponsors such as
General Motors, Ameritech and Monsanto.<BR><BR>This interest
is encouraged by such investment notables as William F.
Sharpe. Sharpe, the recipient of the 1990 Nobel prize in
economics and widely regarded as one of the foremost experts
on investing, titled a presentation he gave on market neutral
investing as, "A Modest Proposal to Revolutionize the
Investment Management Industry."<BR><BR>This paper will
describe market neutral investing and summarize the issues
that financial planners should consider in determining the
proper role for a market neutral strategy.<BR><BR><FONT
color=darkred size=3><STRONG>What is 'Market
Neutral'?</STRONG></FONT><BR><BR>Market neutral investing is
an investment technique that combines the purchase of
undervalued securities with the short sale of overvalued
securities in such a way as to neutralize the impact of the
overall market for that type of security. This strategy is
also referred to as a "zero beta" strategy. This is because,
since the portfolio is neutral to the overall market, the
portfolio has no volatility or co-movement with the overall
market.<BR><BR>Market neutral strategies have been employed
using various asset classes such as fixed income, currency,
risk arbitrage, linked-security arbitrage and hedged
strategies. Some examples of linked securities (securities
that are contractually connected to one another) are index
futures and the underlying securities in the index,
convertible securities and warrants and the underlying
security; options on stocks and index futures, and depository
receipts and the bundles of underlying common stock traded in
other countries.<BR><BR>Market neutral strategies also are
called absolute return strategies since the return is
independent of the performance of the underlying market and
hence a return may be generated whether the market goes up or
down.<BR><BR>This paper will only address market neutral
investing as implemented in a U.S. stock portfolio with equal
dollar amounts in a long component and a short
component.<BR><BR>The strategy is implemented as follows. The
manager identifies undervalued stocks and overvalued stocks.
He or she purchases a portfolio of undervalued stocks so that
the portfolio of longs has the same risk characteristics as
the portfolio of stocks the manager has identified as
overvalued. The manager borrows (through an intermediary known
as the "prime broker") the portfolio of overvalued stocks and
sells them. The cash received from the sale is used as
collateral and earns roughly a T-bill return until the manager
"covers" the short sales. The manager does this by buying the
shorted stocks after they have declined in price (or at least
not appreciated as much as the long portfolio has) and
returning them to the original lender. The portfolio's return
is determined by the interest earned on the cash collateral
plus the differential performance between the long portfolio
component and the short portfolio component.<BR><BR>The return
is not tied to the performance of the market. The long
portfolio is expected to gain the market return plus some
additional return from the selection of undervalued stocks. In
addition, the short portfolio (of equal dollars) will lose the
market return, but gain some additional return from having
shorted overvalued stocks (which will either have gone down
more than the market or at least not appreciated as much as
the long portfolio component). Thus, the combined portfolio of
the longs and shorts will cancel out the return from the
market. All that is left will be the difference in performance
between the long and the short portfolio components (plus the
return earned on the cash collateral).<BR><BR><FONT
color=darkred size=3><STRONG>Negative
Aspects</STRONG></FONT><BR><BR>One potential negative aspect
of market neutral investing concerns possible tax
consequences. However, the tax implications of market neutral
strategies are somewhat complicated. One important distinction
has to do with the type of investment vehicle. In a
partnership (the typical structure for a hedge fund), the
expenses of the fund (including management fees and dividend
"expense" on the shorts) are typically not deductible for tax
purposes. In a mutual fund, these expenses are typically
deductible, providing a major advantage for the after-tax
returns of a market neutral mutual fund.<BR><BR>Another
complication is that market neutral strategies will have
higher turnover. This is due to the fact that there are two
portfolio components (a long and a short) that will each have
turnover. Also, the turnover on the long portfolio component
is modestly increased to the extent that matching the risk
characteristics of the short portfolio involves more turnover
than the turnover required from a traditional long portfolio
that simply needs to control the deviations from a benchmark.
A good estimate is that for a market neutral manager with
tight risk control, this might increase turnover by about 25
percent.<BR><BR>Another important issue is the distinction
between ordinary income and long-term capital gains. The
interest earned on the cash proceeds of the short sales, which
is used as collateral, will be ordinary income and will be
partially offset by the fund's expenses. (Typically, the
dividends on the longs will be similar in magnitude to the
dividends on the shorts, and will thus offset each
other.)<BR><BR>The key issue then becomes the classification
of the capital gains. Even though the turnover in market
neutral accounts can exceed 200 percent a year (with the
combined long and short turnover), the turnover is not the
same for every security in the portfolio; therefore, some
portion of the gains will be long-term. All transactions
related to securities sold short are classified as short-term,
so the breakdown between short-term and long-term is
critically dependent on whether the market is up or down in a
given year.<BR><BR>In an up market, the gains will tend to be
long-term. That is because it is likely that both the longs
and the shorts will increase in value. However, if the manager
has stock selection skill, then the longs should appreciate
more than the shorts (a liability.) In contrast, in a down
market, the longs will likely decline so gains will not be
generated. However, the longs would be expected to decline
less than the shorts. The decline in value of the shorts is,
of course, realized as gains-not losses, as in the case of the
longs-through the mechanism of short selling. All these gains
from short selling will be classified by (regulatory)
definition as short-term.<BR><BR>The net result is that in a
strong up market, a low percentage of gains could be
classified as "ordinary." However, the flip side is that in a
down market, a high percentage of gains could be classified as
"ordinary."<BR><BR>One needs to balance the potential negative
impact of taxes with the possibility that market neutral
portfolios provide enough additional return to, at least
partially, compensate for any added tax burden. While there is
limited data on the performance of (equity long/short) market
neutral managers, some of the studies that have been done are
encouraging.<BR><BR>For example, a recent study done by the
consulting firm BARRA looked at the performance of 14
quantitative market neutral managers over the period
1990-1997.<SUP>1</SUP> All 14 managers had positive
information ratios (a measure of skill). BARRA also compared
the information ratios (after fees) produced by these market
neutral managers with the information ratios produced by two
large samples of typical long-only managers. One sample
consisted of 367 institutional portfolios and the other sample
consisted of 300 mutual funds. In both cases, the market
neutral managers produced superior information ratios compared
with the long-only managers.<BR><BR>Another study covering the
five-year period ending November 30, 1997, found that its
sample of market neutral managers had an average annual
compound return (net of fees) of 14.08 percent and a standard
deviation of 2.09 percent.<SUP>2</SUP> That compared favorably
with the Lehman Aggregate Bond Index return of 7.61 percent
and standard deviation of 4.46 percent.<BR><BR>A study by the
Frank Russell Company concluded that for the five-year period
ending December 31, 1997, the average market neutral manager
in their universe delivered over six percent a year in added
value.<SUP>3</SUP><BR><BR>While the limited sample of market
neutral managers studied and the potential of survivorship
bias should make one cautious in relying on these and other
performance studies, the number of different studies all
showing positive results is at least intriguing.<BR><BR><FONT
color=darkred size=3><STRONG>Risks of Market
Neutral</STRONG></FONT><BR><BR>There are four main sources of
risk that a financial planner needs to evaluate before
investing with a particular market neutral manager.<BR><BR>The
most obvious risk is that the manager may not possess any
stock selection skill. However, even if the manager possesses
no skill, the portfolio returns would be expected to equal the
T-bill return. On the other hand, if the manager's stock
selection is perverse and the stocks he or she selects as
undervalued underperform the stocks the manager had identified
as overvalued, then the manager could contribute a negative
return that could reduce or swamp the expected T-bill return.
(Obviously, if you did find a manager whose selection ability
was perverse, you could just reverse their selections and make
money.)<BR><BR>However, even if a manager has been able to
identify undervalued stocks, it does not necessarily mean that
they are equally adept at identifying overvalued stocks.
Indeed, the biggest risk in this regard is that the manager's
stock selection process may not normally generate both
undervalued and overvalued candidates. Contrast two different
managers.<BR><BR>The first is a quantitative manager who
normally ranks the stocks in his selection universe from most
attractive to least attractive. This manager would not have to
change his selection process to implement a market neutral
strategy. On the other hand, a manager who spends all her time
searching out unique undervalued stock situations may have to
double her efforts to also search out unique overvalued stock
situations. And there is no guarantee the manager is equally
adept at identifying overvalued stocks. One cannot assume the
manager's skills will apply equally to undervalued and
overvalued stocks.<BR><BR>If, for this manager, identifying
overvalued stocks does require the same amount of effort as
identifying undervalued stocks, then one needs to consider how
all the manager's assets are invested. If 90 percent of the
manager's assets under management are invested in long
portfolios and she is adding a market neutral strategy as one
more product, then how many resources are going to be
allocated to identifying overvalued stocks, given that most of
the manager's fee income comes from identifying undervalued
stocks?<BR><BR>Another example would be a manager whose skill
is in identifying undervalued and overvalued industries. His
performance may come from his overweighting the undervalued
industries and underweighting or deleting the overvalued
industries rather than from his stock selection skills within
an industry.<BR><BR>Since the correlations among many
industries are not high, it is unlikely that the industries
the manager selected as undervalued would have the same risk
characteristics as the industries the manager identified as
overvalued. Buying the semi-conductor industry and selling
short the chemical industry may produce a market neutral
portfolio in the sense that the beta may possibly be zero.
However, the portfolio will still be subject to significant
industry risk. (See discussion of common factor risk
below.)<BR><BR>The manager's ability to measure and control
beta or volatility is an important risk factor. If the
portfolio does not have a beta close to zero, it will not be
market neutral. For example, if the long portfolio has a beta
of 1.3 (it tends to exacerbate movements in the overall market
by 30 percent), and the short portfolio has a beta of 0.90 (it
tends to go up or down only 90 percent as much as the market),
the combined portfolio of 100 percent in the longs and 100
percent in the shorts will not have a zero beta. The combined
beta (1.3 minus .90) will be .40. Thus, the portfolio will be
exposed to 40 percent of the market's movement rather than
totally neutral.<BR><BR>While it is true that no one knows
beforehand what the true beta of a portfolio is, there are
better and worse ways of estimating it. The beta estimate is
also dependent on the level of diversification in the
portfolio. A beta estimate for an individual stock will have
much more error than the beta estimate for a well-diversified
portfolio.<BR><BR>Common factor risk is also critical.
Remember, the key to controlling risk in a market neutral
strategy is to make the long portfolio similar in risk profile
to the short portfolio. This way, the returns will be
completely dependent on the manager's stock selection skill
and not any systematic or market-wide factors. While beta
attempts to measure the systematic or market related risk, one
cannot ignore exposures to common factors. These are factors
that may not affect all securities but will affect groups of
securities. The most obvious common factors are industries,
value/ growth and large/small capitalization. For a portfolio
to be truly market neutral and only dependent on the manager's
stock selection skills, the common factors of the long and
short portfolio must be as closely matched as possible-while
still allowing the manager enough flexibility to exploit his
or her valuation insights.<BR><BR>Short selling also
introduces a risk factor. Short selling, or shorting, is
different from the typical long portfolio strategy in two
ways. First, there must be someone who owns the stock who is
willing to lend it. Second, since you must return some time in
the future the equivalent number of borrowed shares of the
stock, you could lose more than the maximum 100 percent loss
of a normal (long) purchase. If the stock you have shorted
goes up 400 percent before you purchase it to return to the
lender, you have lost 400 percent of your investment in that
stock.<BR><BR>Having a diversified portfolio with no
individual large-stock short positions, and shorting only
stocks with ample lending availability are two ways that the
risks of shorting can be minimized. But it is incumbent on the
financial planner to understand the specific characteristics
of shorting and how the manager deals with it.<BR><BR><FONT
color=darkred size=3><STRONG>Benefits of Market
Neutral</STRONG></FONT><BR><BR>First, the returns are not
dependent on the systematic returns of the underlying asset
class. Thus, the manager is as likely to have a positive
return in down markets as in up markets. This decoupling of
the portfolio return from the underlying asset class return
enhances the flexibility in using a market neutral
strategy.<BR><BR>With the use of futures, the manager's alpha
(risk-adjusted excess return) is portable to any asset class.
For example, if you believe that it is less likely that a
manager can add an alpha when investing in the larger stocks,
you could buy S&P 500 futures and overlay it on the market
neutral manager's portfolio. In this way, the benchmark can
still be the S&P 500 return, but it may be more likely
that the client will get an alpha. To the extent there is a
liquid futures market, the financial planner can focus on
finding the best market neutral manager and not be restricted
to finding superior managers in every style or asset
class.<BR><BR>Freeing up a manager so his or her investment
decisions are no longer tied to the composition of a specific
benchmark creates some potential trade-offs. On the one hand,
the manager no longer needs to have an opinion about every
industry represented in the benchmark. The manager can invest
in just those industries or groups where he or she has
opinions about the stocks within those specific industries or
groups. The manager could go so far as to specialize in just
one industry.<BR><BR>On the other hand, whatever industries or
groups the manager focused on, they would have to offer a
broad enough range of both undervalued and overvalued
candidates so that the manager could create a long portfolio
with the same risk characteristics as the short
portfolio.<BR><BR>If implemented correctly, market neutral may
be the most risk-efficient asset available. That claim is
based on two unique features of market neutral. First is the
correlation of market neutral with other assets-it's zero.
Unlike fixed income and its interest rate risk, market neutral
has no exposure to systematic risk. Indeed, while market
neutral is expected to have zero correlation with the S&P
500, over the last five years, intermediate-term government
bonds have had a correlation of 44 percent (R2 of about 20
percent). The import of this can be seen in Chart 1. This
chart shows the risk-reducing impact of adding different
percentages of intermediate-term government bonds or a market
neutral portfolio to a portfolio invested in the S&P
500.<SUP>4</SUP> What this demonstrates is that even if the
market neutral manager produced no alpha, it still would have
been a superior risk-reducing asset to intermediate-term
government bonds.<BR><BR>This exercise was repeated in Chart
2, but using international equity as an asset class. Again,
because there is significant correlation with the S&P 500
(MSCI EAFE had a correlation over the last five years with
S&P 500 of 45 percent), using international stocks in a
portfolio reduces risk, but not as much as the market neutral
portfolio.<BR><BR>Also consider that the risk of a market
neutral manager is all risk specific to the particular
manager. Thus, it can be diversified away. A portfolio of
several market neutral managers might be the most efficient
asset choice of all. For example, the market neutral manager
shown in Chart 1 had a standard deviation about equal to
intermediate government bonds. However, the risk of
intermediate government bonds is almost entirely
undiversifiable systematic risk-that is, interest rate risk.
But the risk of the market neutral manager is not systematic.
It arises from the supposedly unique stock selection method
that particular manager employs. Hence, it can be effectively
diversified away when combined with other market neutral
managers. Therefore, by definition (no systematic risk), a
portfolio of market neutral managers-assuming even a minimal
level of stock selection skill-will be the most efficient
risk/return asset available.<BR><BR>Another way a market
neutral portfolio is efficient is that it is there to produce
pure alpha. There is no diversification deadweight. When a
manager has as his or her benchmark an index of the underlying
asset class (such as the S&P 500), the manager's active
portfolio is only the portion that deviates from the weights
in the index. Indeed, based on such factors as tradition, risk
control and the manager's business risk, the typical approach
is for the manager to overweight or underweight individual
stocks and industries relative to the benchmark. However, this
usually results in high correlations with the benchmark. The
typical institutional equity portfolio has an active risk of
about 4.5 percent, according to BARRA. Even that level of
active risk may be suspect, depending on how accurate the
chosen comparison benchmark is. Other studies have shown that
the majority of manager active risk is related to style and
not stock selection. For example, in one study of 1,286
diversified U.S. equity funds, the average percent of active
risk due to style was over 83 percent. That is, most of the
typical active manager's risk could be duplicated with a
passive portfolio representing a manager's style. What you are
paying active fees for and hoping to benefit from-the
manager's unique stock selection skill-tends to be the least
significant portion of the risk/return package you get from a
manager. However, market neutral reconfigures this frustrating
situation. Instead of an insignificant portion of the
manager's risk/return package coming from stock selection, the
entire risk/return profile of market neutral is determined by
the manager's stock selection skill (and the manager's ability
to control risk, of course).<BR><BR>With a market neutral
portfolio, which has no systematic risk, the most appropriate
benchmark would be an asset like U.S. 90-day T-bills. Hence,
by definition, every stock position in the long and the short
portfolio is an active position. This fact has interesting fee
implications.<BR><BR>One could argue that the efficiency of
the strategy translates to fee efficiency. This may be quite
surprising to investors when they compare the typical market
neutral fee schedule with the management fees charged by more
traditional managers. There is a range of fees charged by
market neutral managers, but the most common is "1 and 20";
that is, the manager charges a flat 1 percent of assets plus
20 percent of the excess return above the T-bill
benchmark.<BR><BR>How could that fee be more efficient than a
traditional fee that might be in the range of 60 basis points?
First, consider that the 60-basis-point fee is charged on the
entire portfolio, even though only 10 percent of it may be
"active." Thus, to make the fees comparable to a market
neutral portfolio where 100 percent of the assets are active,
you would have to multiply the 60 basis points
ninefold!<BR><BR>Second, consider that the fees for a
traditional active manager are based on the value of the
assets. For example, if the active manager didn't add any
value above an index fund, the manager's fees would still have
increased by the increase in the market. (Some adjustments
would have to be made for the fact that most active fee
schedules decrease as assets increase.) Over the last five
years, fees would have increased (for a manager with the
S&P 500 as the benchmark) by over 150 percent due just to
the increase in portfolio value from an appreciating
market.<BR><BR>On the other hand, the fees for a market
neutral manager would not have increased at all due to market
appreciation. The increase in fees would only come from the
added value of the portfolio due to the manager's active
decisions.<BR><BR>In summary, a market neutral investment may
be an asset that financial planners want to consider for
several reasons: returns do not depend on the systematic
returns of the underlying asset class, there is increased
flexibility in exploiting a manager's stock selection skill,
and there is potential for superior risk/return trade-off both
in terms of the market neutral portfolio itself, as well as
its impact on the overall risk/return of a client's total
portfolio. <BR><BR><FONT color=darkred
size=3><STRONG>Suggested Reading</STRONG></FONT>
<OL>
<LI>Ken Gregory and Susan Belden, editors, "Market Neutral
Investing: Birth of a New Asset Class for Mutual Fund
Investors," <EM>No-Load Fund Analyst</EM>, December 1997.
<LI>Bruce I. Jacobs and Kenneth N. Levy, "20 Myths about
Long-Short," <EM>Financial Analysts Journal</EM>,
September/October 1996, pp. 81-85; Jacobs and Levy,
"Long-Short Equity Investing," <EM>The Journal of Portfolio
Management</EM>, Fall 1993, pp. 52-63.
<LI>Ronald A. Lake, editor, <EM>Evaluating and Implementing
Hedge Fund Strategies</EM> (Euromoney Books, 1998).
<LI>Jess Lederman and Robert A. Klein, editors, <EM>Market
Neutral</EM> (Chicago: Irwin Professional Publishing, 1996).
<LI>Richard O. Michaud, "Are Long-Short Equity Strategies
Superior?" <EM>Financial Analysts Journal</EM>,
November-December 1993, pp. 44-49. </LI></OL>
<P><FONT color=darkred
size=3><STRONG>Endnotes<BR></STRONG></FONT></P>
<OL>
<LI>Andrew Rudd, "What's the Market for Market Neutral?" a
BARRA unpublished research paper, June 1998.
<LI>Blaine Tomlinson, "Market Neutral Investing,"
<EM>Alternative Investment Strategies</EM>, Sohail Joffer,
editor, 1998, pp. 52-53.
<LI>As reported in <EM>Pensions & Investments</EM>, May
4, 1998, Vol. 26, No. 9, p. 43.
<LI>The market neutral portfolio used in this example was
that of a market neutral manager who has a good record at
risk control. See Appendix for a list of the data used.
</LI></OL>
<P><EM>Mark T. Finn is principal of Vantage Consulting Group
in Virginia Beach,
Virginia.<BR></EM></P></DIV></SPAN></SPAN></DIV></SPAN><FONT
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