How will rising rates impact market neutral investing?

From my limited understanding, being market neutral is valuable because if you're consistently returning LSD-MSD positive alpha, you can use leverage to boost returns.

  1. Is that wrong?
  2. As rates rise, does the minimum threshold of acceptable returns to make the model work rise as well?
  3. Whats the limit to the mode if rates rise to 4%-5%, wouldn't performance need to exceed interest rates?

Comments (21)

Arthur Digby Sellers, what's your opinion? Comment below:

Interesting question - my gut says higher rates are bad for the MMs (for the reasons you mentioned), but hopefully someone who knows what they're talking about can validate

Shadows, what's your opinion? Comment below:

For L/S equity, cost of leverage is fixed as long as you are balanced between long and shorts

(You pay for leverage on your long, and you get payed on your short)

If short term rates increase too much, indeed there is a risk of reallocation : why would u take the risk to give money to a HF to hope for 5% if risk free rates are yielding 5%. However most HF target higher returns so as long as they keep delivering it should be ok

Finally HF also put all their unused cash on risk free rates, so they also benefit from that. Imagine you have 3X leverage, with 10% collateral it uses only 30% of your cash. So you have 70% invested in risk free rates, hence benefiting from the higher rates too.

Most Helpful
Shadows, what's your opinion? Comment below:

You take leverage through a bank's prime brokerage service / PB.

So you don't really hold stocks, you hold swaps on stocks, which work almost like futures, except it is not centralized by a compensation chamber, it is just you vs the bank.

I just need to explain how longs work to then explain shorts.

How does it work in pratice if u buy a stock:

You enter a swap with the PB: you send 10% of the amount needed to the PB as collateral and then every day you will exchange with the bank the variation of price. If the stock goes up 2%, the PB will send u those 2% in cash, if it goes down 2% u will send it to the PB.

To be properly hedged, the PB has just bought the stock for real to be able to replicate the performance to you. So the PB is short a swap with you and long the stock, hence no risk.

But as the PB bought the stock they had to use some cash from their own balance sheet (as u sent only 10% of the amount needed to buy the stocks) this is why they make u pay the risk free rate.

By entering a swap you implicitely borrowed money to the PB.

Now when u want to short:

As u probably now you need someone that holds a share to lend it to you in order to be able to short.

This is where the PB is there again. So you can short only if the PB can lend u a share. They can lend u a share only if they hold shares. And as we saw earlier PB hold shares for all their clients that want to be long stocks through swaps. So imagine the big PB like MS, they hold shares in every single stocks.

To short a stock you will enter a swap with ur PB, same principle as a long: u send 10% collateral, u exchange performance every day.

To be able to replicate the performance, your PB will sell the stock so that he is long swap and short stocks.

So the PB sold a stock and therefore received some cash for it. So the PB has more cash thanks to u shorting. So the PB pays u the risk free rate on this cash.

Hope this helps

  • Analyst 3+ in HF - Other

Sounds like a lose lose for HFs this way.

1. rates are low -> equities are up -> why invest with HFs when stocks are climbing 20% annually

2. rates are high -> equities go down -> why invest with HFs when risk free rate is so high.

tbh most MM HFs like Millennium and Citadel are >10% / year consistently. Think that's a pretty good reason to invest in them no matter the macro backdrop. You're giving me a completely neutral new asset class yielding 10% annualised. That's amazing.

  • Analyst 3+ in HF - Other

Para 1 is me describing how awful things are if para 2 and 3 are true. Para 2 is what people and journalists always say about HF returns. Para 3 is what OP is saying. Para 4 is my view. 

HFPM, what's your opinion? Comment below:

Not to mention fee pool growing because funds capture incentive fees on rates too (unless they have a hurdle which few public equity funds do).   

If I am capable of generating returns of 5% over interest rates, then when rates are 0%, I make 5%, keep 1% (20% of 5%) as my fee and leave the investor with 4% net which is 4% over rates. 

If rates go to 5%, I generate 10% gross, keep 2% as my fee, return 8% net to the investor which is only 3% over rates. And I've made 2% for myself. 

So for the same performance, I have made twice the fee.

HFPM, what's your opinion? Comment below:

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