In focus

Why equity market neutral strategies could be valuable in a crisis


Prior to the Covid-19 pandemic, investors were already assessing an extended economic cycle for signs of weakness or moderation. The first quarter of 2020 saw the worst falls for global equities since the global financial crisis, and measures imposed to contain the virus look to be leading the global economy into recession.

Now more than ever, investors are assessing the nature of risks in their portfolios. We believe the ability to gain more targeted risk exposure offered by equity market neutral (EMN) strategies could be especially valuable if widespread recession takes hold.

EMN strategies are a type of hedge fund strategy that allow investors to take active positions while keeping exposure to market risk low. There is neither a prescribed approach nor hard definition for these strategies. That said, they all look to eliminate the need for the wider market to move in a particular direction to generate returns. Investment professionals typically refer to this as having limited net exposure or limited “beta”.

Why use market neutral strategies?

An EMN approach aims to isolate stock specific risk and focus on exposure to individual opportunities rather than broad market exposure (beta). We believe that there are always fundamentally good and fundamentally bad companies, a fact that can be masked by the overall direction of the market.

Because an EMN approach looks to limit broad market participation, the strategy tends to be inherently defensive in nature. It may lag a given index during strong bull runs, but can offer valuable downside protection during market downturns, and dampen volatility when added to a broader portfolio.

The pursuit of this type of low correlation, low volatility strategy means EMN strategies are often used for their diversifying properties.

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In 40% of the worst 10 months for global markets in the last 20 years EMN strategies have delivered a positive return. In all of the above months, EMN strategies have performed more favourably than MSCI World, and on average returned 10.2% more per month.

How do they work?

The strategies operate by taking both long and short positions. These can reflect conviction in a single security with market exposure neutralised. For example, one position may be a short in an individual stock, and the other half of the trade may be long an index. This type of trade would seek to benefit from only the expected underperformance of the individual stock relative to the market.

Alternatively, the strategy can hold pairs trades. These may seek to take advantage of dislocations between sectors or regions that have historically displayed a more predictable relationship. As an example, two stocks within the same sector may have significantly different valuations. One might be undervalued and another overvalued in an investor’s opinion. In this case, an investor may seek to be long the undervalued stock and short the overvalued stock. This exposes the strategy to stock specific risk, whilst removing the sector specific risk.

EMN strategies will almost always use leverage, allowing managers to add conviction and/or manage risk in either leg of the trade. The level of leverage taken will depend on the forecasted risk/return of the strategy.

How do investors use market neutral strategies?

EMN strategies could be considered either as part of a diversified portfolio’s alternatives allocation, or could be used to augment an investor’s equity allocation. In either event, the goal is an aggregate increase in diversification, reducing risk as measured by volatility and drawdown, whilst retaining stock specific risk.

The below chart shows a traditional 60/40 equity bond split and a 50/40/10 split, in which the 10% allocation is to an EMN index. 

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Adding a 10% allocation to EMN can maintain an attractive and comparative return profile whilst reducing the volatility profile and the maximum drawdown. This demonstrates the diversification benefits that can be observed by including this kind of strategy within a broader portfolio.