Market Neutral Investing: Exploring the Potential Benefits and Sources of Return
Equity markets, especially in the United States have enjoyed quite a run. For periods ended May 31, 2017, the S&P 500 has returned 8.7% year-to-date, 17.5% for the trailing 12 months and 10.10% annually over the past three years. Volatility, despite a spike during the summer of 2015 and more recently related to last year’s presidential election, has declined to historically low levels. Economic growth appears to be stabilizing in many parts of the world and growth has returned to the Eurozone. Even Emerging Markets have rebounded from three years of negative returns. Why diversify away from equities?
While we believe that the fundamental backdrop for equities is positive from an absolute sense and perhaps more attractive relative to bonds, the benefits of diversifying your investment portfolio with strategies that are expected to exhibit little-to-no correlation with the broad equity and bond markets still remain. Moreover, as the US continues into its second longest economic expansion over the past 50 years, there are macro and market conditions that may interrupt this most recent period of high risk adjusted returns for equities.
- The bull market in the S&P 500 is in its ninth year; the second longest in post-World War II history and the run has pushed the forward P/E ratio to a ten-year high.
- Bond yields, while rising post the presidential election, are still at historic lows with limited room torally unless economic growth declines.
- Political risk is on the rise as populist sentiment grows (BREXIT, Trump) and acts of terrorism appear to be increasing.
- Disconnect in the capital markets as both "safe haven" assets (gold and bonds) and risk assets (equities, bitcoin) are rallying. Something has to give.
The Invesco Quantitative Strategies team believes one potential way to buffer the effects of market downturns, volatility and rising interest rates is to add market neutral equity strategies to traditional portfolios, as they potentially offer a unique approach to generating return regardless of the general movements of the equity and bond markets. Many market neutral equity strategies are designed to strip away all other exposures (i.e. beta, sectors, size) by creating offsetting long and short positions; therefore, returns are driven primarily by stock selection, and are a purer representation of a portfolio manager’s skill. Market neutral equity strategies may offer several potential benefits,including:
- Very low levels of correlation to other asset classes (stocks, bonds and commodities) that may represent a significant portion of investors’ portfolios.
- Lower levels of total volatility, which may lower risk further.
- A history of attractive downside protection during extreme market stress, as these strategies typically exhibit near-zero beta exposure.
- Opportunity for higher returns in a rising interest rate environment.
Market neutral equity strategies offer a unique style of investing and typically seek to produce attractive returns for investors whether the larger equity markets are climbing, falling or bouncing around in a narrow range.
Unlike traditional equity strategies, where portfolio managers can only generate returns by buying stocks that they expect to perform well, managers employing a market neutral equity strategy can also borrow and sell stocks expected to perform poorly in a process known as “short selling,” or “shorting.” Long positions profit when the price of an investment goes up, and short positions are designed to profit when the price of an investment goes down. To produce attractive portfolio returns, the stocks being held long must outperform the stocks sold short, thus earning a positive “spread.”
Take for instance a hypothetical situation where a portfolio holds a long position in one financial services firm, such as a bank, but holds a short position on another bank. In this scenario, the portfolio manager has effectively neutralized the client portfolio’s exposure to fluctuations in the banking industry and will make or lose money only based on the relative performance of the two stocks.
Due to their unique investment approach, market neutral strategies offer several important potential benefits to investor portfolios, including diversification from traditional asset classes, the ability to dampen overall volatility, a cushion against severe equity market declines and a return boost from rising interest rates.
Investing is a classic tradeoff between risk and return. One of the ways investors attempt to manage and mitigate the risk part of that equation is by combining strategies that differ within and across asset classes to help diversify their return pattern over time. Using this approach, investors’ wealth creation is not tied to the fortunes of just one or a few investment options. Furthermore, with all else being equal, the lower the correlation of one investment option to another, the greater the potential for reducing overall volatility across the investment lineup.
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