Equity market neutral?

Can someone clarify for me. If the point is to eliminate/negate systematic risk (the equity risk premium), then aren’t you banking mostly risk-free like returns? A) wont you always underperform the mkt then if the market goes up? b) why not just invest in treasuries then and C) if the point is about picking stocks then why hedge with a short if you’re confident the one you chose will increase?

I realize you can double up (one up and one down) and of course you can still profit if the market is down but just seems like you can underperform quite offer as well, no?

Thanks is advance

You would invest in an equity market neutral hedge fund if you want to be in stocks but obviously don’t want the market risk. You wouldn’t rather invest in Treasuries if you think bonds will lose money. So go with an absolute return HF so you’ll theoretically definitely make some money (not lose money).

The point is to pick good stocks yes, but the overarching theme is I don’t want market exposure - hence the shorts. But the fund will still gain from both longs & shorts - it’s just that they cancel each other out b/c the goal of the fund is to be hedged.

An equity portfolio manager’s return is beta (what the market returns) + alpha (what the manager’s skill returns).

Market neutral strategies, as the name implies, make you immune to equity market risk (systematic risk), what’s left is the manager’s skill.

If you think some stocks, industries, or sectors are overprice relative to others then there’s a potential profit to be made from corrections in the prices. You buy undervalued stocks and sell overvalued stocks. The point of this strategy is to profit from mispricing, not equity market exposure … hence you don’t want beta, so you go long / short such that overall you are hedged from market moves in either direction (no more beta) and all that’s left is the alpha (mispricing corrections). You need to go long short because the point is to exploit relative mispricing.

Why do you say that elminating systematic risk gives you risk free returns? That would be the case if you sold a forward. However, the hedge is based on going long/short which is an active decision so it wouldn’t generate a risk free return becuase there is the risk of the relative prices not moving as you expected.

Only if all securities plot along the SML.

(The good news: they don’t.)

I guess I was thinking that if you look at capm and and remove the systematic risk component (and therefore the equity risk premium), then all that’s left is the risk-free rate.

Say your long return on a stock is 12% and the required return was 10%, meaning that you’re alpha was 2%. It seems like by going mkt neutral that you’re always settling for the 2% instead of the 12%.

It can get a bit confusing when the book says “remove exposure to systematic risk”. The way I think of it is hedging a return. So the CAPM gives a return estimate Re = [Rf + B*(Rm - Rf)], this estimate is the fair return for simply investing in a stock. All of those market variables are fixed except for B which depends on the stock -> this is why I think the book refers to hedging systematic risk, because B is the main determinant of Re, but we want to hedge Re not B. In my view, hedging beta is the same as hedging the return on the stock -> but this is just a saying and can get confusing when you look at the CAPM formula

Let’s say the CAPM return is 10% (required return) and you believe the stock will actuall return 12% due to growth potential the market does not know about, you discovered this yourself, it’s your alpha. Simply buying the stock gives you Re + Alpha = 12%.

The point of a market neutral fund is to only capture your alpha (the 2%). That 10% is determined by the market and you can’t control it. That’s why you hedge the systematic exposure - you only want to capture what you can control (assuming you are correct). If the market went down, and the stock went down 5% (down 7% based on CAPM return), would want to be exposed to that? Being hedged means you don’t lose 7%, plus you actually gain 2% because you correctly predicted it was underpriced by 2%. You’ve given up potential upside to be safe from the downside, that way you can focus on generating purely alpha which is what market neutral hedge funds do.

Again the focus is on relative mispricing, you short some and long some which provides the hedge. Then hopefully, the short positions decline in value relative to the long positions and / or the long positions increase in value relative to the short positions to capture the return to your research (alpha).

So you are basically conceeding that if the market for a stock goes up 12% (you’re long), then you are only pocketing the 2% bc presumably you’re short cancelled out the other 10% gain?

So even though in that instance you are coming away with a much smaller gain (2% < 12%), you also don’t suffer the full losses when they occur?

That interpretation sound accurate? Two thoughts though:

1.) If it’s about stock picking and you’re confident in your selection, why not just take the long position and book the 12% gain and not hedge?

2.) It seems like your gains are rarely very big if you’re booking returns of only 2%, no?.


Because, although you’re good at picking stocks, you may be poor at anticipating market movements; being market neutral means that you’ve eliminated the variable you’re poor at estimating.

Correct. But you’re presumably making those gains whether the market goes up or down. Plus 2% always is better than +12% half the time and -10% half the time.

You’re welcome.

Yes, I agree with your interpretation. regarding your two questions, you take the 2% over 12%, because you just don’t know if the market will go up or down. If your confident that it will go up, then take the risk…and you can expect to earn the 10%. As the guy above me said, your specialty might not be predicting market movements so why expose yourself? Also, even though you invest in equities the point of the fund is not to be exposed to the equity market, its to be exposed only to your stock picking skill. And yeah, earning 2% consistently over a long period quickly adds up compared to gain in one year, a loss in the next and so,

Thank you both.

I guess it just seems that if I wanted to settle for nominal returns, then I would just invest in a 20-year treasury or something like that. And even though in theory you don’t suffer the losses, it just seems like the market return plus the occassional loss would still outpace the 1-3% annually, but maybe not.

A couple points:

  1. hedge funds use leverage so that magnifies returns (and losses if they screw it up but that’s another matter). It’s not just a matter of clipping 2%.

  2. most hedge fund investors hold equities already, they are exposed to the market. What is the point in paying $$$ to a hedge fund manager to give you the same product? The value of hedge funds lies in their ability to provide DIFFERENT sources of return than what you already have.

Great feedback!. Thanks to everyone for the help!

Totally agree especially point 1 which some people misunderstood on the 2%. Equity neutral is highly leveraged due to the ability to generate positive cashflow from the short position to fund the long. Thus the return based on the investment base can be much greater than 2%.

And if done right, the entire systematic risk is hedged and return is based on just the managers stock selection skill.