Main points

• Market neutrality refers to an investment strategy employed by investment managers that seeks to profit from rising and falling prices in financial markets.
• Investment options for this market neutral strategy aim to avoid significant losses as long and short positions are hedged against each other.
• Hedge funds typically use market neutral strategies because their investment objectives are absolute returns rather than relative returns.
• The two main market neutral strategies used by fund managers are fundamental arbitrage and statistical arbitrage.
• Market neutral strategies have very low positive correlation with the market because they make specific bets on the convergence of stock prices while hedging overall market risk.

Understand market neutrality

There is no single widely accepted approach to implementing a market-neutral strategy. In addition to the methods mentioned above, market neutral strategists may also use other tools, such as merger arbitrage, shorting certain industries, etc.

Managers who hold market neutral positions are able to take advantage of any momentum in the market. Hedge funds typically take market neutral positions because they focus on absolute returns rather than relative returns. A market neutral position might involve taking a 50% long and 50% short position in a specific industry, such as oil and gas, or the same position in the broader market.

Generally, market neutral strategies are similar to long/short equity funds, although there are significant differences. Long/short funds aim to take advantage of undervalued and overvalued opportunities by adjusting their long and short equity exposures based on industry movements.

Market-neutral strategies, on the other hand, focus on concentrated bets based on pricing differentials, with the primary goal of achieving zero beta against their appropriate market index to hedge against systemic risk. Although market neutral funds use long and short positions, the objectives of this fund category are significantly different from ordinary long/short funds.

Types of market neutral strategies

Fund managers mainly employ two market-neutral strategies: fundamental arbitrage and statistical arbitrage. Fundamental market neutral investors use fundamental analysis, rather than quantitative algorithms, to predict a company's future development and trade based on expected stock price convergence.

Statistical arbitrage market neutral funds use algorithmic and quantitative methods to discover stock price differences based on historical data. Then, based on these quantitative results, fund managers trade stocks that are likely to revert to the price mean.

One advantage of market-neutral funds is that they place a strong emphasis on mitigating market risk when constructing their portfolios. During periods of high market volatility, historical data shows that market-neutral funds tend to outperform funds using certain other strategies.

Aside from pure shorting strategies, market neutral strategies typically have the lowest positive correlation with the market, primarily because they specialize in making specific bets on the convergence of stock prices while hedging overall market risk.

Example of Market Neutral Fund

Because it is a market neutral strategy, Vanguard Market Neutral Investor Equity Fund (VMNFX) is a liquid alternative fund that operates by using a long and short strategy, whereas the company's other mutual funds only buy and sell long positions. The fund's strategy is designed to minimize the impact of the stock market on its returns, which means the fund's returns may differ significantly from market returns.

While most funds that short stocks, such as hedge funds, remain private because SEC rules do not require disclosure of their short positions, the Vanguard Market Neutral Investor Equity Fund does publish its short positions.

The fund selects short positions by evaluating companies' performance across five categories: growth, quality, management decisions, market sentiment and valuation. It then creates a composite expected return for all stocks in its investment universe and shorts the stocks with the lowest scores.

Investing in market neutral specific funds is typically aimed at high net worth individuals. For example, VMNFX has a minimum investment of $50,000. Other funds may have extremely high expense ratios, much higher than the investment ratios of passively managed funds.

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