Shifting to Neutral

Market neutral strategies work in volatile markets

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gear shiftSince 2007, the global equity and bond markets have presented institutional investors with a variety of challenges in managing pension assets. On the equity side, they include broad equity returns falling below their long-term averages, increasing correlations across asset classes and more macro-driven market sensitivity as exhibited by the VIX index. From a bond perspective, yields are at historic lows and institutional investors are beginning to consider the future impact of falling bond prices. As a result, more plans are both considering and implementing a wide range of alternative investment strategies.

Because of the flexibility a market neutral strategy offers investors, it can be a very useful component for portfolio construction in volatile markets. A well-constructed market neutral strategy seeks to neutralize various risk factors such as dollar exposure, security betas, industry sectors, market caps, regions, and styles. As a result, the return stream should come from idiosyncratic stock selection – the manager’s ability to pick stocks, long and short, or alpha.

With one strategy, investors can address a variety of portfolio challenges. According to the Pyramis 2012 Global Institutional Investor Survey, Canadian investors are considering alternative investment strategies (both illiquid and liquid) for a variety of applications. Some investors consider alternatives a source of uncorrelated returns while others view them as a tool to dampen equity risk. Approximately 18% of Canadian institutional investors surveyed expect to increase their exposures to liquid alternatives over the next one or two years. Among liquid alternatives, managed futures/CTAs and market neutral strategies are options being considered.

A U.S.-based public plan, CalPERS, recently announced that its equity market neutral allocation would go from 3% to 10%, making it one of the fastest-growing parts of the plan’s absolute return portfolio. Like many institutional investors, CalPERS is looking for non-correlated strategies to diversify the overall portfolio.

Why are so many plan sponsors considering equity market neutral strategies? There are three basic reasons:

De-Risking – Investors often implement a market neutral strategy in their fixed income portfolio because it exhibits the risk and return characteristics of traditional fixed income and isn’t correlated to bonds. In an environment of rising interest rates, market neutral strategies have traditionally done well. They can also be used in a liability-driven investing approach.

Return-Seeking — Investors have used market neutral strategies in their stock portfolios to reduce the volatility of their directional equity exposure and to increase the portfolio’s overall efficiency.

Alternatives Allocations — For investors with exposure to a variety of alternative investments, market neutral strategies have historically exhibited low to no correlation while offering superior liquidity characteristics.

When evaluating market neutral strategies there are a few important factors to consider. By understanding the risk factors the strategy has neutralized (e.g., beta, sectors, caps and countries), investors can judge a manager’s ability to deliver a diversified alpha return as opposed to making single factor bets. Further analysis can bring insights as to how these return streams benefit the overall portfolio. At the same time, with the increased regulatory environment surrounding alternatives managers it is important to fully evaluate a manager’s operations, reputation and alignment of interests.

In general, if you look at the potential benefits from market neutral investing, you will find that the strategy generally offers consistent low volatility over shorter and longer market cycles. Market neutral strategies also deliver attractive risk-adjusted returns and have negative to low correlations with many traditional long-only benchmarks, such as equities, fixed income, real estate and high yield. And, in he end, market neutral strategies deliver all of these benefits in a highly liquid fashion.

Joseph H. Morgart is Senior Vice President of Alternative Investment Strategies, Pyramis Global Advisors

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