Market neutral strategies, as the name implies, are investment strategies that show neutrality to market trends.
What does that mean?
It means that the profitability of the strategy is not related to the performance of the market in which it operates.
It is a non-directional strategy. With this type of strategy we do not seek to guess where the market will move. Regardless of whether the market rises or falls, a market neutral strategy will look for constant and little volatile results.
Theory: a zero Beta portfolio
Reviewing the theory a bit we see that “A market neutral portfolio is a portfolio or set of assets whose Beta equals zero”.
If we remember the theory on the Alpha and Beta of a stock, we saw that according to the CAPM theory, the profitability of a share was determined by two components: Alpha and Beta.
That is, an element dependent on market profitability (this is Beta) and a residual element (called Alpha).
If we remove the dependence to the market (we equate Beta to zero) we will obtain a neutral portfolio, and we will see that the only way to obtain profitability is by Alpha.
Note: We recall that the theory says that this Alpha performance is not related to market performance.
Therefore, we should focus on Alpha and not Beta. According to CAPM, the expectancy for this residual Alpha is equal to 0. So, since the expectation of the mean is 0, it is reasonable to expect a reversal-like behavior to the mean (the value oscillates around a mean). And this behavior is what we seek to exploit with our trading system
How to build zero beta systems?
The idea is simple, combining long and short positions on different financial assets.
-β (asset a) + β (asset b) = 0
The most illustrative example is the pair trading:
What is a pair trading strategy?
The pair trading strategy is the typical example of market neutral and is based on statistical arbitrage.
The trader operates with two assets that tend to “move together”.
When the distance between them (spread) expands, what we predict is that they come together again. When the distance between them is shortened, what we expect is that they expand back to their usual relative positions. It is for this reason that the pair trading systems are classified as market neutral. If while we have our positions open, both assets rise or fall simultaneously, there will be no change in the value of our operation. What we lose in one leg we gain in the other. Our profit objective is in the spread.
Advantages and disadvantages of market neutral strategies
- We are not subject to the market behaviour, we can see that in periods where for example the S&P 500 is clearly bearish and the strategy continues to earn money. So it is a good option to diversify our portfolio of investment systems.
- The need for portfolio financing is reduced: Short sales finance the long trades.
- Lower volatility.
- Small benefits. When the market takes a strong trend, the profitability that we will obtain with statistical arbitrage is lower than with a trend following system.
- Zero Beta does not mean zero risk. Neutralizing market risk does not mean that trading with these types of strategies is without risk.
- Problems with the estimation of Beta.
When we estimate Alpha and Beta of an asset, we are simply doing that: Estimating. The values that we obtain today will not be the same as those we will obtain tomorrow since with each new data the estimation may vary. This makes difficult the pairs combination to make an exact coverage.
- Is a neutral strategy the same as taking some long positions and other short sales?
No. A portfolio that has some long and short positions at the same time does not mean that it is market neutral.
The differential factor is in seeking to neutralize market risk and this is achieved by adapting the size of each position.
- Is Hedging a neutral market strategy?
It is not a strategy as such but a technique or way to reduce the risk of the positions of our portfolio.
- How to calculate the sharpe ratio in neutral type systems?
In neutral-type strategies (for example a pair trading strategy), when calculating the Sharpe ratio, the interest rate of a risk-free asset should not be taken into account.