Market neutral L/S equity: what is it?


How does a fund that runs a market neutral L/S equity strategy work?

Say I analyze a stock in the telecom sector and I come to the conclusion that it is 30% undervalued. What happens next? Do I buy this specific stock and simultaneously go short the whole telecom sector? Do I go short the whole market?

What am I earning in the end? Only the performance of the stock ABOVE its peers? So I'm not benefiting at all of, let's say, the superformance of the telecom sector above the market?


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Comments (7)

Oct 28, 2014

my knowledge somewhat limited here, so someone correct me if I'm wrong, but mkt neutral tends to be a fund that has as much upside as downside they are indifferent if the overall market moves up or down since their positions (theoretically) are not correlated with the overall mkt.

So in order to actually achieve something that is truly "market neutral" or even close, you'd have to have a pretty equal weighting short vs. long (whether that is stocks/bonds/derivatives, etc is really fund specific)...

That's my very rudimentary understanding. Someone with more experience in HFs, feel free to correct me and/or expand on this...


Oct 29, 2014

I only know how it's defined by a few select "megafund" HFs but the strategy is a bit of a misnomer as it is based mostly off being industry neutral, which in turn is market neutral given how companies within the same industry trade together (i.e. you'll see news on how disappointing Citi earnings has hurt JPM and BAC shares even if the latter two haven't reported yet).

Market neutral is the strategy of "pairings". PMs and analysts will be assigned an industry and even a specific sub-sector of that industry (i.e. restaurants or 3D printing) and cover 30-60 names. Within those names, the team is (generally) assigned to pick one long and one short. I'm simplifying this as there are also box strategies and other portfolio management tactics.

This way, even if the entire industry is down say, 30%, as it was for 3D printing earlier in the year, you'll still win since your short fell more (3D systems) than your long did (Stratasys) and the opposite for a bull market.

The main thesis here is that if you can pick a winner (i.e. Chipotle) and a loser (Mcdonalds) within an industry, you'll win on how much better the winner does over the loser, no matter what happens to the general industry or market.

The pros of this strategy is mostly for business continuity and why you'll see large HFs/mutual funds employ it. Good risk and capital preservation vs.. a traditional long/short fund. The con is that it's hard to really "kill it" and do well to make a very large carry. However, large funds care more about continuing the fund model and minimizing redemptions.

Rest of this is opinion, but why this strategy is looked down upon by some in the industry is the perception that these funds are mostly feeding themselves with the management fee and not so much the carry. Furthermore, it's hard to really know the inside-outs of a particular company if you're covering 60 names and you spend a lot less time per name when you're scanning your industry and trying to make 20+ earnings calls in a given week. Finally, these funds are usually momentum and quarterly focused, so it's pretty short-term vs. the more deep dive long-term fundamental strategies. You'll need to be fast and nimble to work in most market neutral funds, especially during earnings season. While some of these funds tell you that they are 1-2 year focused, you'll get trashed if you're wrong for one to two quarters.

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Oct 29, 2014

Thanks a lot, great answer.

Oct 29, 2014

Market neutral L/S equity tends to refer to funds that have an average of less than 10% net exposure, usually both dollar-value and beta. Most market neutral funds tend to be systematic since its very hard to maintain less than 10% net exposure otherwise

Oct 29, 2014

A lot of what SanityCheck describes can be true for some places, especially multi-manager/pod-style funds, but it's not necessarily "because" they're market neutral in and of themselves (for example a lot of what he said would also describe SAC which was/is not really a "market-neutral" fund).

Let me take a stab at explaining "market-neutral" from a more abstract level.

On a basic level, "market-neutral" means the fund is going to target having little or no "net exposure." "Net Exposure" can be defined a couple different ways:
It can mean zero (or limited) "net long", meaning the notional/market value of long and short positions is matched
It can mean it can mean zero (or low) beta to the S&P (basically the same as the above, but with the ratios and hedges set up to target zero BETA rather than an absolute zero notional).
It can be the above with an extra wrinkles like zero targeted sector beta
Or it can mean zero (or limited) beta to a more complicated/multi-factor model
These things can be applied on a position level (like the earlier poster's Stratsys example), on a pod/PM level, or on a whole fund level (And multi-manager funds are often "rehedged" on an aggregate level)

In practice, the application of this can vary a lot. Some places re-balance the portfolio nightly with no leeway from PMs, others allow some deviance (net long/short) within certain thresholds, etc.

What all this means in practice is that the fund is going to try to eliminate as much market correlation/beta as possible, and isolate the actual underlying stock pick in each [trade/theme/portfolio/etc].

The point of doing this is to isolate the true underlying "alpha" (outperformance) of a given [stock/PM's portfolio/etc].
In practice this often means that the face-level "total" return may not be very high; however, there are two factors that can offset this:
a) The returns should (within certain parameters) be uncorrelated to the market-institutional investors place a lot of value on this
b) The strategy can employ a lot of leverage, because the "sum of the parts" of the portfolio[s] doesn't have much net exposure to the ups and downs of the market (in theory)

This is commonly used in multi-manager/pod-style setups because it also allows the "main"/feeder fund to allocate to a bunch of different teams independently trying to generate alpha, and reallocate funds quickly to the "hot hand." Millenium and Citadel Surveyor are well-known examples of this.

I also have to disagree with SanityCheck's assertion that analysts are stretched too thin in this model; many of the people I know who work in these strategies have a comparable number of positions on at any given time to analysts at "regular" long-short funds.

Oct 29, 2014

Working in one of the largest multi-strategy (heavy L/S equity) hedge fund, I'd say it is extremely rare to see a market neutral, fundamental driven L/S Equity fund, although many advertise them as market neutral (real market neutral refer to beta

Most real market neutral funds are those using systematic/quantitative driven strategies due to their short term focus and high trading frequency.

Several reasons:

1. most fundamental L/S equity funds have a fairly long term investment horizon (6m to 2+ years). keep a market neutral strategy in long horizon basically mean giving up a lot of free beta since market is up trending in long term and nobody (at least in equity fund) could predict the market.

2. beta is backward looking and is only effective in short period. also its value could change dramatically in long period. in order to keep a true beta neutral fund, pm need to balance portfolio frequently. since most hf only have a handful of names, one name beta change without adjust exposure would significantly add/reduce beta of portfolio.

3. pair trading is dangerous in long term. many idiosyncratic events could happen and cause disastrous result (e.g a name you short suddenly got acquisition offer at 20% premium).

my fund usually manages beta to 0.4-0.6 range and use a combination of market short, industry short and peer short to hedge.

Oct 29, 2014