I have recently been investigating the hedge fund market. I am interested in the benefits that I could derive from a long/short (or market-neutral) equity fund. I would appreciate an independent, objective view on this type of investment and a detailed explanation of how it works.
Imagine McDonald's has just launched a low-fat burger that your children love. Burger King's new fat-free burger, on the other hand, is dry and tasteless. Sensing a trend here, you rush out and buy £5,000 worth of McDonald's shares and sell short £5,000 of Burger King. Selling short means selling a stock that you do not own on the assumption that its price will fall, then buying it back later at a profit. What you have just done is become a market-neutral investor.
There are many hedging strategies that provide some degree of market neutrality but balancing investments among carefully researched long and short positions – an approach called market-neutral long/short equity trading – is truly market-neutral. Taking the McDonald's/Burger King example, if the market goes up, both McDonald's and Burger King will rise in price but McDonald's should rise more, provided that your analysis is correct and is ultimately recognised by other investors. Thus, the profit from your McDonald's position will more than offset the loss from your short position in Burger King. As a bonus, you will receive a rebate from your broker on your short position (typically, the risk-free rate of interest).
Managers of market-neutral long/short equity hedge funds make scores of investments like this by picking stocks they believe are sufficiently balanced to keep the portfolio buffered from a severe market swing. Typically, they make sure the baskets of long and short investments are beta neutral. Beta is the measurement of a stock's volatility relative to the market. A stock with a beta of one moves historically in sync with the market while a stock with a higher beta tends to be more volatile than the market and a stock with a lower beta can be expected to rise and fall more slowly than the market.
Many practitioners of market-neutral long/short equity trading balance their longs and shorts in the same sector or industry. By being sector neutral, they avoid the risk of market swings affecting some industries or sectors differently than others and thus losing money on long stock in a sector that suddenly plunges and short in another sector that stays flat or goes up.
In effect, what managers try to do by being beta-neutral and sector neutral is make their portfolios more predictable by eliminating all systematic, or market, risk.
Keeping portfolios balanced is therefore an obvious part of market-neutral long/short equity trading. This can involve a tremendous amount of buying and selling and, thus, one of the risks – or variables – in this strategy is the fund manager's ability to execute trades efficiently, as well as to keep dealing costs from eating away at the profits.
Fund managers must also trade in very liquid stocks – usually stocks which have options written on them, indicating a high level of daily volume – in order to ensure that they can get quickly in and out of positions.
The main variable, however, and the key to the success of this strategy, is the fund manager's ability to select a basket of long stocks that will perform better than the basket of shorts. If the longs do not outperform the shorts – that is, if your assessment about McDonald's edge in product development translating into better stock value is wrong – then, no matter how market-neutral your portfolio is, it will not generate meaningful returns.
Most market-neutral, long/short equity funds use quantitative analysis to assist in stock picking. This involves studying historical price patterns to project how well a stock will perform in the future. Typically, these stocks will then be given a ranking from one to five, with stocks ranked one and two expected to perform better than those ranked four and five.
Not surprisingly, quantitative analysis often requires the aid of high-speed computers to quickly assess historical patterns, identify their relationships with current trends and provide the rankings. It also often involves short-term trading, as there is more precision in measuring historically the impact of an event on prices over a period of several days than there is measuring over a longer term.
In short, through sophisticated quantitative systems, fund managers seek to optimise their stock picks and produce a higher Sharp ratio or risk-adjusted rate of return.