After strong gains in the stock market in 2013, many investors are beginning the New Year with portfolios that are heavily allocated to equities. Rebalancing portfolios back to fixed income investments would normally be a sensible tactic; however, the high likelihood that interest rates will rise in the coming years means that the expected return for fixed income may be negative again in 2014. The increasing universe of liquid alternative strategies may provide an answer for the investor who would like to reduce exposure to the equity markets while also avoiding the potential losses in fixed income due to rising interest rates. Market Neutral Equity in particular might be an interesting alternative worth exploring since it should not be correlated to either the equity or the bonds markets.

A “market neutral” equity investment strategy attempts to hedge out the risks that the overall market will decline. This is done through short selling. In a short sale, an investor makes money when a stock declines. 100% long minus 100% short = zero market exposure. In this case, you have “hedged” out all of the exposure to the market, and are therefore “market neutral”. If the volatility of the stocks in the long book and short book differ meaningfully, an investor may balance out the volatility (i.e., Beta) by having fewer of the higher volatility positions. This is called being "Beta-adjusted Market Neutral."  

For example, if an investor were to own $1,000 of stocks (i.e., “long positions”) and $1,000 of short positions, the investor would likely make money on the longs and lose money on the shorts when the broad market is rising. Conversely, an investor would likely lose money on the longs and make money on the shorts when the market is declining.

As a result, in a typical market neutral portfolio, an investor would generally expect to do worse than the market when the market is climbing, but would expect the opportunity to outperform the market when it’s declining. Beating the market when the market is declining is the “benefit of the hedge.” Underperforming the market when the market is climbing is the “cost of the hedge.”

When well designed, the short book helps protect the long positions from the risks of broad market events, and the potential returns of that market neutral portfolio should be fairly independent of these macro-events, over time. Examples of the macro events that a market neutral portfolio can potentially protect against include, but are not limited to: rising real interest rates1, the potential for rising inflation, terrorist attacks, recessions, and any other event that could make the whole market go down.

Until recently, alternative investment strategies like market neutral equity were only available to high net worth and institutional investors through separate accounts and private funds. However, there is now a small universe of market neutral equity mutual funds, with minimums as low as $1000, available to all investors for purchase through the same channels as traditional mutual funds.

There are several benefits to incorporating Market Neutral Equity funds into your portfolio. This strategy is a good way for investors to lower overall risk exposure to both equity and fixed income and still be able to capture favorable uncorrelated returns. A market neutral portfolio will also generally make money overall to the extent that the long book beats the broad market average plus the extent to which the short book underperforms the broad market average.

There is no one-size fits all portfolio allocation, and we encourage people to consult with their financial advisor, but a good starting point for a market neutral allocation might be 10% of an overall portfolio.

1Real Interest Rates - The real interest rate of an investment is the nominal current interest rate minus the rate of inflation. To a borrower, the real interest rate more accurately reflects the cost of borrowing since the effects of inflation have been removed.