how hedged are market neutral funds

coffeebreak's picture
Rank: Monkey | banana points 45

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?

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Comments (9)

Feb 11, 2019

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.

Feb 11, 2019

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.

Feb 11, 2019

but that's beta. What about sector, momentum, size, volatility etc risk?

Feb 11, 2019

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.

Feb 11, 2019

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%?

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Most Helpful
Feb 11, 2019

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.

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Feb 11, 2019

when you say unleveraged, you mean on the capital that the PM has been given, correct? The capital base they're working with probably is already levered.

Though its kinda crazy, one fund's 'alpha' is another's risk factor. I guess anything that has an etf is probably something that can be hedged. But still, the distinction gets murkier as the field evolves.

Feb 11, 2019

Yes, when I say "unleveraged" I am referring to the capital a given PM has been given. That capital is probably composed of a relatively small equity capital base with considerable leverage on top, but the PM does not really care (and may not even know) what the funding structure is that is providing him or her with capital. To the PM, there is simply $X million to deploy.

And yes, the way hedging and risk is defined can become highly counter-intuitive, and indeed creates some difficulties in putting one's views into play. For instance, let us say a PM wants to put a lot of money into a fast-growth, rapidly re-valuating sector (like SAAS companies a year or two ago). The PM might say, "the market is in the process of realizing how attractive this sector is, and we can participate in the revaluation." The quants/risk managers might say instead, "you are very long momentum; cut it out" and/or might hedge away all the alpha by automatically using relatively similar companies as hedges. It is tricky to define the boundary between an unplanned exposure vs. an explicit bet.

Feb 11, 2019
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