How does a market-neutral investing strategy generate returns?
I'm an undergrad who is interested in L/S investing but I'm a bit confused on how net market neutral L/S equity actually produces returns. If you go long on a forestry company stock and short another to minimize the downside risks of the forestry industry getting crushed, how are you generating positive returns since if the forestry industry goes up, any monetary gain on the long position would be offset by a monetary loss from the short position? Would you hedge your long position by shorting a firm with lower beta stock?
bc you are not shorting the industry, you are shorting the company.
so if the industry goes up, you are betting that the company you are long goes up by more than the amount the short goes up
In the example you are describing you are betting that forestry stock A will outperform B. You are purposefully neutralizing the sector impact by picking two stocks in the same sector. So don’t think about it as “forestry goes up” if the sector as a whole goes up due to sector dynamics, then yes in a perfect L/S you don’t make money, but that’s not the bet. The bet is that there are specific things about company A that will make it outperform B, regardless of what happens to the overall market or sector.
and an edit: if you short with lower beta all you are doing is taking a long sector view in addition to A vs B (if sector goes up higher beta will go up more than lower beta so it is a sector bet).
Got it. So would you hedge a long position by taking a short position in a company with the same beta as the long position stock or do HFs care more about the idiosyncratic reasons why the firm's stock will fall and assign less importance to matching beta?
Beta is important because it tells you how much of company B you should short in order to counteract the market risk incurred by buying A, or vice versa. But yeah, you're right, the point of going long-short is precisely because you're able to make a bet about company A vs company B without being exposed to price movements in the particular industry that they're in or the overall market.
you're beta and factor neutral at most market neutral funds to so you're getting paid to capture alpha - the idiosyncratic and uncorrelated return aspect of a single-name stock.
fwiw you don't need to understand this as an undergrad; I have an internship with a market-neutral fund (Millenium/Citadel/P72) and wasn't expected to understand what that is.
Thanks for explaining. I'm not super familiar with these firms but I'm surprised to hear that you don't need to understand the concept of market neutral to work there - I thought they had very rigorous 4-5 round interview processes for internships.
Not really, the interviews mostly test your ability to analyse businesses and stocks and see what your thought process is like and whether or not you're creative. They can teach you the specific ins and outs of the strategy later but that doesn't impact your ability to analyse a company or investment opportunities as an undergrad.
You can check it out mathematically. Assuming you have two stocks in similar industries, the beta is going to be the same right ideally. So - if you think one outperforms the other on a relative value basis, you will still make money regardless of whether the market goes up or down if you employ a long short strategy.
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