So I'm wondering how much hedging do market neutral L/S funds actually do?
I mean, there are some funds that claim to be market neutral but they seem to hold a basket of 10-20 longs and balance that out with some shorts (not necessarily with considerations to beta).
Then there's the other extreme where I guess you can hedge out everything that has an etf (would you?).
I'm curious, what are the main risk factors that market neutral funds hedge out?
How does this change for L/S managers vs. stat arb funds?
part of the portfolio construction process for market neutral funds is constraining the portfolio such that the dot product between the stock weight vector and vector of stock betas is equal to 0, which over time leads to an overall market beta of very close to 0.
Deep is correct. Essentially the portfolio is uncorrelated to the market hence why its neutral, beta 0. They're trading the relative performance, whatever that may be... they can't be totally risk free, then they wouldn't make any money.
but that's beta. What about sector, momentum, size, volatility etc risk?
In practice most major market neutral funds are also hedged to both factors (momentum, value, etc.) and sector exposure, though some of the smaller ones are comfortable making some (explicit or implicit) sector or factor bets. Typically though, market neutral funds are fairly tightly hedged on almost any dimension you could think of.
You're referring to L/S funds at multimanagers right? I have seen fundamental funds where they do no such explicit hedging of factors / sectors / markets at all.
Secondly, if you hedge all these risk factors out what would a good return for a sector specific fund look like? Say we assume a sharpe of 2. Assuming fairly tight risk limits, 10%?
Correct, I am thinking of the multi-managers, who are very tightly hedged.
I also know of a few smaller non-multi-managers. Those smaller funds, from what I understand, are not always as sophisticated from a risk-control and hedging perspective.
In terms of the return profile, you are looking at less than 10% without a doubt, probably more like 5%, on an unleveraged basis. Your 2-sharpe assumption feels about right, but it's hard for me to be sure. I've never seen well-aggregated data for a multi-manager's overall or pod-specific sharpe, though I've heard numbers around a 2 tossed around.
Keep in mind that market neutral funds are almost always levered at least a few turns, as the volatility of the strategy is quite low. The analysts and PM do not really know what the % return is on the underlying equity capital, nor do they care all that much, though they might monitor unlevered % return as a secondary metric. They get paid on their dollar PnL; the amount of leverage backing their strategy is not their concern.
The whole thing's a scam
Depends on whether the long/short manger is claiming to be beta neutral, dollar neutral or both
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