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What Are “Market Neutral” Hedge Funds?

Across the risk spectrum in the hedge fund universe, “global macro”, representing roughly 5% of all hedge funds, is at the far end, representing the most risky strategies. Somewhere in the middle of the spectrum lies “equity long/short” which is probably the most common hedge fund strategy and also the easiest to understand. In these funds, a manager will be both “long” and “short” stocks. (“Long” simply means owning a security–one profits with rising markets. Being “short”, on the other hand, requires borrowing a security and selling it with the intention of returning the borrowed security when it can be repurchased at a lower price–one thus profits from declining markets.) If the long and short positions are of equal value the effects of general market trends, whether up or down, are effectively neutralized. Returns depend on the manager’s ability to identify the direction of the securities in the portfolio. This strategy seeks high returns and has commensurate risk.

 

One of the least volatile general categories is called “market neutral.” Funds of this type seek their returns in strategies designed to be insulated (or hedged) from the general direction of bond and/or equity markets. Unlike equity long/short in which the long and short positions are independent of each other, in market neutral strategies the positions are structured to hedge out particular risks associated with each position. Therefore, these funds have very little correlation with the stock market and can create a diversifying effect that further reduces the risk to an investor’s overall portfolio. Many of these strategies attempt to profit by capturing price inefficiencies in the financial markets and involve convertible securities, bonds, warrants, mortgage-backed securities, common shares, and a wide variety of derivative instruments. These types of funds are often referred to as “arbitrage funds.”

 

While academic research has shown arbitrage funds to be among the most stable of investment vehicles, this does not mean that they are risk-free. Some portfolio managers attempt to counter the risks of these strategies by including some strategies that are intended to profit most at times when markets are least stable and conditions are unfavorable for many arbitrage funds. (Please see our Presentation on Arbitrage.)