Market Neutral Long/Short Equity Trading
by Dion Friedland, Chairman, Magnum Funds
Imagine McDonald’s has just come out
with a low-fat burger that you and your children love. Burger King’s new
fat-free burger, on the other hand, is dry and tasteless, producing moans in the
back seat. So, sensing a trend here, you rush out and buy $5,000 worth of
McDonald’s stock and sell short $5,000 of Burger King. What you have just done
is become a market-neutral investor.
There are many hedging strategies that
provide some degree of market neutrality, but balancing investments among
carefully researched long and short positions – an approach I call
market-neutral long/short equity trading – is truly market neutral. Taking the
McDonald’s-Burger King example, if the market goes up, both your McDonald’s
and Burger King positions will rise in price, but McDonald’s should rise more
provided your analysis is correct and is ultimately recognized by other
investors. Thus, the profit from your McDonald’s position will more than
offset the loss from your short position in Burger King. As a bonus, you will
receive a rebate from your broker on your short position (typically the
risk-free rate of interest).
Managers of market-neutral long/short
equity hedge funds make scores of investments like this, picking stocks they
believe are sufficiently balanced to keep the portfolio buffered from a severe
market swing. Typically, they make sure the baskets of long and short
investments are beta neutral. Beta is the measurement of a
stock’s volatility relative to the market. A stock with a beta of 1 moves
historically in sync with the market, while a stock with a higher beta tends to
be more volatile than the market and a stock with a lower beta can be expected
to rise and fall more slowly than the market.
For added "neutrality," they
can buy equal dollar amounts of long and short investments, making the portfolio
Finally, many practitioners of
market-neutral long/short equity trading balance their longs and shorts in the
same sector or industry. By being sector neutral, they avoid the risk of
market swings affecting some industries or sectors differently than others, and
thus losing money when long a stock in a sector that suddenly plunges and short
another in a sector that stays flat or goes up.
In effect, what managers try to do by
being beta neutral, dollar neutral, and sector neutral is make their portfolios
more predictable by eliminating all systematic, or market, risk.
Keeping portfolios balanced, then, is
an obvious part of market-neutral long/short equity trading, especially when
trying to maintain a constant dollar-neutral portfolio. This can involve a
tremendous amount of buying and selling, and thus one of the risks – or
variables – in this strategy is the fund manager’s (and his broker’s)
ability to execute trades efficiently as well as to keep brokerage costs from
eating away at the profits. Fund managers must also trade in very liquid stocks
– usually stocks which have options written on them, indicating a high level
of daily volume – in order to ensure they can get quickly in and out of
The main variable, however, and the key
to the success of this strategy is the fund manager’s ability to select a
basket of long stocks that will perform better than the basket of shorts. If the
longs don’t outperform the shorts – that is, if your assessment about
McDonald’s edge in product development translating into better stock value is
wrong – then no matter how market neutral your portfolio is, it won’t
generate meaningful returns.
Most market neutral, long/short equity
funds use quantitative analysis to assist in stock picking. This involves
studying historical price patterns to project how well a stock will perform in
the future. Typically, these stocks will then be given a ranking from 1 to 5,
with the stocks ranked 1 and 2 expected to perform better than those ranked 4
and 5. Not surprisingly, quantitative analysis often requires the aid of
high-speed computers to quickly assess historical patterns, identify their
relationships with current trends, and provide the rankings. It also often
involves short-term trading, as there is more precision in measuring
historically the impact of an event on prices over a several-day period than
there is measuring over a longer term.
Of increasing use to fund managers
employing this strategy are neural networks, a new generation of artificial
intelligence that simulates the processes of the brain. Able to actually
"learn" from past calculations and optimize their results, neural
network computer programs can help identify stocks within a particular sector
that behave together in a particular, coherent way and then find pricing
misalignments among these stocks. Neural network programs identify the most
likely outperformers and underperformers in a particular sector by looking at
variables such as the relationship between the current price and the price in
the recent past, and the interrelationship between prices of various equities.
Other variables include data from the options and other related derivatives
markets that help forecast future performance by indicating what the markets
"think" about this stock today. Not only reading the various data,
neural networks learn to interpret them, picking up complex patterns in the
indicator data and the relative importance of certain indicators on particular
In short, through sophisticated
quantitative systems using technology such as neural networks, fund managers
seek to optimize their stock picks and produce a higher Sharpe Ratio, or
risk-adjusted rate of return.
Quantitative funds were recently the
target of negative media coverage following the severe losses by Long Term
Capital Management, Ltd., a U.S. hedge fund. The negative attention focused on
the fact that Long Term Capital failed despite the technical wizardry of its
management team, which included Nobel Prize winners Robert Merton and Myron
Scholes, and despite its claim of being market neutral. In fact, Long Term
Capital was not market neutral in the sense in which I am defining the term.
Rather than balance long and short equity positions, Long Term Capital bet on a
convergence of spreads between various fixed income sectors, which is not a
truly market neutral strategy, as prices of bonds can - and, in fact, did -
Further, Long Term Capital
Management’s losses were caused by the use of an extreme amount of leverage,
up to 30 times its capital, which is atypical of market-neutral long/short
equity funds. Such funds, in general, leverage no more than three or four times
capital, with most using significantly less leverage than that.
While quantitative analysis is the most
common method for identifying optimal long and short positions, some hedge fund
managers rely on fundamental analysis, systematically analyzing industries and
companies to find those on the brink of positive, or negative, change. One
strategy known as "pairs trading" matches its long and short
investments one pair at a time. When a manager finds a company that is
particularly outstanding, he seeks a mate on the short side that doesn’t have
to be an unattractive company so much as one that is expected to perform
marginally poorer and, equally important, that is most likely to swing in the
same way in a volatile market (i.e., one that has the same beta) and thus insure
against potential losses. A perfect example is the McDonald’s-Burger King
pairing discussed above. The same is true when searching for a long match to a
particularly compelling short candidate.
Deriving returns from the performance
differential within the pair, this approach seeks to achieve consistency of
return by earning small, steady profits on many positions, rather than trying
for large gains that may end up being equally big losses.
This tendency to earn small, steady
gains characterizes market neutral long/short equity funds in general, resulting
in annual returns of about 10-12 percent, unlevered. To enhance returns, some
funds resort to leverage.
This is the inherent tradeoff with the
strategy of balancing long and short investments as a safeguard against market
risk. Obviously, it cannot reap (without leverage) the same gains from a roaring
bull market as an aggressive, long-only growth manager.
But balanced long/short equity trading
– by managers with strong stock-picking ability – can provide consistently
good performance in any market and even excel in a market decline. Which, in
today’s investment climate, is an attractive feature to investors.