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Questions and Answers About Market Neutral Investing 13 lio from long and short positions rather than achieving neutrality via a derivatives contract based on an underlying index. Jacobs: This reflects the fact that long-only portfolios are generally con- strained by the weights of the names in the underlying index, whereas market neutral long-short portfolios, if properly constructed, are free of index weights. This is most noticeable when you look at stock under- weights. Given that the market capitalization for the median stock in the U.S. equity universe is 0.01% of the market’s capitalization, a portfolio that cannot short can achieve, at most, a 0.01% underweight in the aver- age stock; this underweight is obtained by excluding the stock from the portfolio. The manager may have a very negative view of the company, but the portfolio’s ability to reflect that insight is extremely limited. The manager that can sell short, however, can underweight this stock by as much as investment insights (and risk considerations) dictate. Levy: It’s important to note that the market neutral long-short portfolio also has greater leeway to overweight stocks, because the manager can use offsetting long and short positions to control portfolio risk. Whereas a long-only portfolio may have to limit the size of the position it takes in any one stock or stock sector, in order to control the portfolio’s risk rela- tive to the underlying benchmark index, the market neutral long-short portfolio manager is not circumscribed by having to converge to bench- mark weights to control risk. The freedom from benchmark constraints gives market neutral long-short portfolios greater leeway in the pursuit of return and control of risk—a benefit that translates into an advantage over market neutral portfolios constructed without shorting. Can I “neutralize” my long-only portfolio by adding a short-only portfolio? Buchan: Yes, but you would miss out on the real benefits of market neu- tral portfolio construction—the added flexibility to pursue returns and control risks that comes from the ability to offset the risk/return profiles of individual securities held long and sold short. Levy: Integrated portfolio optimization results in a single market neutral portfolio, not a separate long portfolio plus a separate short portfolio. But a long portfolio combined with a short portfolio would be market neutral? Jacobs: Yes, but it would offer little advantage over a long-only portfo- lio that achieved neutrality via derivatives positions. c02.frm Page 13 Thursday, January 13, 2005 12:12 PM 14 MARKET NEUTRAL STRATEGIES Wouldn’t it benefit from the diversification provided by a less- than-one correlation between the returns on the long positions and the returns on the short positions? Levy: But the same benefit can be achieved by adding to a long-only portfolio a less than perfectly correlated asset with similar risk and return. The unique advantages of market neutral long-short portfolios come only from an integrated optimization. Will my portfolio be market neutral if I have equal amounts invested long and short? Levy: Not unless the sensitivities of the positions held long and sold short are also equivalent. If the amounts invested are equal, but the betas are not, the portfolio will incur market risk (and returns). An investor might want to place a bet on the market’s direction by holding larger and/or higher-beta positions long than short if the market is expected to rise, or vice versa if the market is expected to decline, but the portfolio in that case is not market neutral. Buchan: It is also important to note that even a beta-neutral portfolio can retain residual exposures to certain market sectors. For example, long positions may overweight the technology sector, relative to the short positions, resulting in a portfolio that is exposed to systematic risk in this sector. A well-designed beta-neutral portfolio, however, will have such exposures only as the result of a deliberate choice on the part of the investor. Jacobs: A similar problem arises in fixed-income market neutral. Mar- ket neutral fixed-income portfolios are generally designed to have matching durations for the longs and shorts; this means that, for a given parallel change in interest rates, price changes in the long and short positions will offset each other. If the term structure of interest rates does not change in a parallel fashion, however (for example, if long rates change less than short rates), price changes in the long and short positions will not be offsetting. It is thus important to determine the portfolio’s expected responses to movements in each part of the yield curve (the short rate, the 10-year rate) and in each sector (corporates, mortgages, etc.). Aren’t short positions risky, or at least riskier than long positions? Levy: It’s true that the exposure of a long position is limited, because the security’s price can go to zero but not below. Theoretically, a short c02.frm Page 14 Thursday, January 13, 2005 12:12 PM Questions and Answers About Market Neutral Investing 15 position has unlimited exposure because the security’s price can rise without bound. In practice, however, this risk is considerably mitigated. First, the short positions will be diversified across many securities. Sec- ond, a substantial (undesirable) increase in the price of a security that has been shorted will in all likelihood be at least partially offset by a (desirable) increase in the price of correlated securities held long. Third, because long and short positions must be kept roughly balanced to maintain neutrality, shorts are generally covered as they rise in price, limiting potential losses. If you’re using short positions to create a market neutral strategy, doesn’t that mean the strategy must be leveraged? Jacobs: Not necessarily. The amount of leverage of a given strategy is within the investor’s control. Although Federal Reserve Board Regula- tion T permits leverage of up to two-to-one for equity strategies, for example, the investor can choose not to lever. Thus, given an initial $100 in capital, the investor could invest $50 long and sell short $50; the amount at risk is then identical to that of a $100 long-only investment. Then wouldn’t you want to avoid leverage in order to avoid the risk it entails? Buchan: Actually, some leveraged market neutral strategies may be much less risky than unleveraged long-only strategies. For example, shorting a Treasury bond futures contract and owning the bond that is deliverable against the futures contract at expiration is a much less risky strategy than a long-only small-cap equity strategy. Furthermore, restricting the choice of market neutral strategies to those that are unleveraged can produce a “leverage paradox,” whereby, in order to achieve a desired return, one may end up choosing an unleveraged strat- egy that is inherently riskier than a strategy that could be “levered up” to produce the same return at less risk. Jacobs: In addition, by using all the strategies out there at the appropri- ate leverage levels (which for some may be no leverage), you can take advantage of the typically low correlations among all the strategies, rather than just a subset. This will produce the least risky portfolio of strategies, as you have the opportunity to diversify risks across many different markets. Levy: Furthermore, long-only portfolios can use leverage, too. However, long-only strategies that borrow to leverage up returns expose the other- wise tax-free investor to a possible tax liability, as gains on borrowed c02.frm Page 15 Thursday, January 13, 2005 12:12 PM 16 MARKET NEUTRAL STRATEGIES funds are taxable as unrelated business taxable income. Borrowing stock to initiate short sales does not constitute debt financing, so profits result- ing from closing out a short position do not give rise to unrelated business taxable income (UBTI). Buchan: In general, when judging any market neutral strategy, the ques- tion should be whether the level of leverage is prudent with respect to the strategy. Clearly, if the strategy involves buying Asian technology stocks and shorting European financial stocks, there is a significant amount of risk (so much, in fact, that few investors would consider such a strategy market neutral). Conversely, if the strategy involves buying stock in a company and then shorting the same company’s American Depositary Receipt (ADR) against the long position, the risk would be relatively small. Jacobs: The same is true for fixed-income arbitrage: The level of prudent leverage is dependent upon the strategy. Buying Japanese government bonds and shorting European corporate securities is very risky; not only are the corporates inherently riskier (and less liquid), but you’re arbi- traging between two very different interest rate regimes. But buying U.S. Treasuries and selling short Eurodollar futures (buying a so-called TED spread), is not, as a trade, very risky. Buchan: Basically, it’s not the leverage per se that matters, but rather the leverage times the risk of the underlying position; or, more succinctly, it’s the net exposure that matters. So some market neutral strategies are riskier than others? Buchan: Clearly, but this is true of investment strategies in general. With market neutral, the riskiness depends to a large extent on the underlying instruments. Mortgage securities, for example, are commonly perceived as quite a bit riskier than government bonds. Even here, however, it is difficult to generalize. Mortgage securities cover a wide range, from highly liquid pass-throughs to unique tranches of collateralized mortgage obligation (CMO) deals; therefore, it is misleading to lump all the different types of mortgage securities in the same group. Many mortgage securities are exposed to liquidity risk and prepayment risk (or, in more formal terms, exhibit negative convexity), and may be difficult to value. But some famil- iarity with these securities reveals that they are not that different from other types of bonds. Take the prepayment risk: as individuals prepay their mort- gages, pass-through securities exhibit negative convexity; when interest rates fall, they increase in value by less than a similar fixed-rate government c02.frm Page 16 Thursday, January 13, 2005 12:12 PM Questions and Answers About Market Neutral Investing 17 security and, conversely, when interest rates rise, they fall by more than the similar government security. But the investor is compensated for these adverse outcomes with a higher yield. Thus, the salient question for the pass-through investor is whether the yield on the security adequately com- pensates for the adverse price risk. Levy: This is essentially no different from ordinary government bonds. Zero-coupon bonds, for example, have lots of positive convexity, on a relative basis, and will therefore often yield less than coupon bonds. There are also liquidity and valuation issues, just as with corporate bonds. Most corporate bonds are illiquid, in the sense that it can cost a lot to trade them. By this measure, many mortgage securities are actu- ally more liquid than corporates. In addition, in valuing a corporate bond, one has to estimate the probability of default and the correspond- ing likely recovery rates—just as one has to estimate future mortgage prepayment rates under differing economic scenarios. Buchan: So mortgage securities are different from but, in general, not necessarily riskier than other bonds used in market neutral strategies. Jacobs: Ken’s comment about the liquidity of corporates reminds me that one should also take into account, when evaluating the risk of a particular strategy, the liquidity of the underlying markets, which may be of critical importance especially for highly leveraged strategies. And another concern I might add is the availability of opportunities in a par- ticular strategy; to the extent that this may limit the ability to diversify one’s portfolio, it can have a considerable impact on risk. Aren’t market neutral strategies best exploited only in certain situations or by investors with special information? Jacobs: I’ve heard it said that market neutral equity strategies only make sense if pricing inefficiencies are larger or more frequent for potential short positions (that is, among stocks that tend to be overpriced) than for potential long positions (stocks that tend to be underpriced). But greater inefficiency of short positions is not a necessary condition for market neutral investing to offer benefits compared with long-only investing. These benefits reflect the added leeway to pursue return and the greater control of risk that derive from the strategy’s freedom from benchmark weight constraints. Levy: It’s also frequently heard that merger arbitrage does not work unless it’s based on insider information. But, as it is practiced in the c02.frm Page 17 Thursday, January 13, 2005 12:12 PM 18 MARKET NEUTRAL STRATEGIES institutional investment community, merger arbitrage is usually based on a public announcement, where the identity of the target, the identity of the buyer, and the rough terms of the transaction are disclosed. Even after such an announcement is made, a spread between the acquirer and the target tends to persist until the deal closes. This spread reflects the very real risks that the deal will not close or, if it does close, it will take a lot longer than expected, reducing the investor’s annualized return. Managers able to analyze these risks correctly have been able to use merger arbitrage to add significant value on a risk-adjusted basis over the past decade. Buchan: A lot of people think convertible bond hedging follows a four- year cycle in terms of returns. Historically, the strategy has underper- formed for a quarter or two every three to four years, in 1987, 1990, 1994, 1998, and 2002, and then proceeded to enjoy a strong recovery in the ensuing year. But what’s behind this pattern? Some of the returns to convertible bond hedging may come from a liquidity premium the con- vertible holder collects in return for holding a relatively illiquid security. If this is the case, then we should see convertible bond hedgers under- performing when liquidity is prized, as these less liquid assets get marked down. In fact, regressing the return of convertible hedgers as a universe on a liquidity measure (such as the spread between Treasury bills and LIBOR) shows that, when the most liquid instruments are highly valued, convertible bond hedging does poorly for the quarter (typically down 2% to 7%). So the question is not whether convertible bond hedging has an inherent four-year cycle but, rather, what makes highly liquid instruments more valuable every four years? But won’t market neutral long-short positions be riskier in general than the positions taken by an index-constrained long-only portfolio? Jacobs: Although a market neutral long-short portfolio may be able to take larger long (and short) positions in securities with higher (and lower) expected returns compared with a long-only index-constrained portfolio, proper integrated optimization will provide for selections and weightings made with a view to maximizing expected return at the risk level desired by the investor. But surely trading costs will be higher? Levy: The trading costs will largely be a reflection of the leverage in the portfolio. If a market neutral equity portfolio takes advantage of the full two-to-one leverage allowed, for example, it will engage in roughly c02.frm Page 18 Thursday, January 13, 2005 12:12 PM Questions and Answers About Market Neutral Investing 19 twice as much trading as a comparable long-only portfolio with the same capital and no leverage. As in any investment strategy, however, it is important in market neutral to estimate expected returns net of trad- ing costs. A market neutral portfolio should not trade unless those trades offer a return above and beyond the cost of trading. But surely management fees will be higher for market neutral than for long-only strategies? Jacobs: If one considers management fees per dollar of securities posi- tions, rather than per dollar of capital, there is not much difference between market neutral and long-only. And management fees per active dollar managed may be lower with market neutral than with long-only. Index-constrained long-only portfolios contain a substantial “hidden passive” element; as their active positions consist of only those portions of the portfolio that represent overweights or underweights relative to the benchmark, a large portion of the portfolio is essentially passive index weights. This is not true of market neutral. Because a market neu- tral portfolio is independent of benchmark weights, its positions can be fully devoted to performance (i.e., to either enhancing return or reduc- ing risk). Levy: Also, most market neutral strategies are managed on a perfor- mance-fee basis, so the fee will reflect the manager’s value-added. Should one use a single manager or multiple managers for a market neutral strategy? Jacobs: Some investors choose to create a market neutral strategy by combining a long-only portfolio with a short-only portfolio or with a derivatives position that neutralizes the long portfolio’s market risk. In these cases, the manager of the long portfolio may differ from the man- ager of the short portfolio or from the overlay manager that looks after the derivatives positions. As we have noted, however, these types of market neutral strategies cannot benefit from the full flexibility afforded by long-short portfolio construction. This goes back to our previous comments on integrated optimization: Only an integrated optimization, which considers long and short positions simultaneously, results in a portfolio that is free of benchmark weight constraints, hence able to exploit fully the risk-reducing and return-enhancing benefits of market neutral construction using long and short positions. An investor seeking these benefits from a market neutral strategy should have it managed under a single roof. c02.frm Page 19 Thursday, January 13, 2005 12:12 PM 20 MARKET NEUTRAL STRATEGIES Buchan: But the same may not hold if you are considering multiple mar- ket neutral strategies. In general, the value-addeds are much less corre- lated across market neutral managers than across long-only equity managers. The reason is there are many more styles of market neutral investing (over 20) than there are of equity investing (growth vs. value, large cap vs. small cap). As long as the managers have the same expected return, one can lower the risk of an overall fund more by using many market neutral managers than by using many long-only equity managers. Is market neutral too complicated for most investors to understand? Buchan: There are two parts to market neutral investing—the strategy and the securities. As I have noted, the strategy itself is typically no more complex than what is being done on a long-only basis, with regard to benchmark-relative investing. There, the issue is how the portfolio will perform relative to the benchmark; here, the issue is how one secu- rity (or basket of securities) will perform relative to another. The other issue is the type of securities used to implement the market neutral strat- egy. Clearly, there are securities that are simple to evaluate and securi- ties that are more complex. But this is independent of whether or not they are being used in a market neutral strategy. How will it fit into a plan’s overall structure? Jacobs: First, it is important to understand that market neutral does not constitute a separate asset class. The asset class to which a market neutral portfolio belongs depends upon how the portfolio is constructed. A mar- ket neutral portfolio is essentially a cash investment (albeit with higher volatility than cash); its value-added is the portfolio’s return relative to the interest receipts from the short sale proceeds. But one can combine a market neutral portfolio with various derivatives positions to obtain exposures to any number of assets—equity, bonds, currency. For example, a position in stock index futures combined with a market neutral portfo- lio results in an “equitized” portfolio; its value-added is the portfolio’s return relative to the equity index return from the futures position. Levy: Plan sponsors can take advantage of this flexibility to simplify a plan’s structure. Using market neutral, they can exploit superior security selection skills (whether in the bond market, the stock market, or the currency market), while determining the plan’s asset allocation mix sep- arately, via the choice of derivatives. In this sense, market neutral can be said to simplify a plan sponsor’s decision-making. c02.frm Page 20 Thursday, January 13, 2005 12:12 PM CHAPTER 3 21 Market Neutral Equity Investing Bruce I. Jacobs, Ph.D. Principal Jacobs Levy Equity Management Kenneth N. Levy, CFA Principal Jacobs Levy Equity Management n market neutral equity investing, the investor buys “winners”—securities that are expected to do well over the investment horizon—and sells short “losers”—securities that are expected to perform poorly. Unlike traditional equity investing, market neutral investing takes full advan- tage of the investor’s insights: whereas the traditional investor would act and potentially benefit only from insights about winning securities, the market neutral investor can act on and potentially benefit from insights about winners and losers. To achieve market neutrality, the investor holds approximately equal dollar amounts of long and short positions. Furthermore, the securities are selected with careful attention to their systematic risks. The long positions’ price sensitivities to broad market movements should virtually offset the short positions’ sensitivities, leaving the over- all portfolio with negligible systematic risk. This means that the portfolio’s value does not rise or fall just because the broad market rises or falls. The portfolio may thus be said to have a beta of zero. This does not mean that the portfolio is risk-free. It will retain the risks associated with the selection of the stocks held long and sold short. The value-added provided by insightful security selection, however, should more than compensate for the risk incurred. I c03.frm Page 21 Thursday, January 13, 2005 12:10 PM 22 MARKET NEUTRAL STRATEGIES MECHANICS Exhibit 3.1 illustrates the operations needed to establish a market neu- tral equity strategy, assuming a $10 million initial investment. Keep in mind that these operations are undertaken virtually simultaneously, although they will be discussed in steps. The Federal Reserve Board requires that short positions be housed in a margin account at a brokerage firm. The first step in setting up a long-short portfolio, then, is to find a “prime broker” to administer the account. This prime broker clears all trades and arranges to borrow the shares to be sold short. Exhibit 3.1 shows that, of the initial $10 million investment, $9 mil- lion is used to purchase the desired long positions. These are held at the prime broker, where they serve as the collateral necessary, under Federal Reserve Board margin requirements, to establish the desired short posi- tions. The prime broker arranges to borrow the securities to be sold short. Their sale results in cash proceeds, which are delivered to the stock lenders as collateral for the borrowed shares. 1 Federal Reserve Board Regulation T (“Reg T”) requires that a mar- gined equity account be at least 50% collateralized to initiate short sales. 2 This means that the investor could buy $10 million of securities and sell short another $10 million, resulting in $20 million in equity positions, long and short. As Exhibit 3.1 shows, however, the investor has bought only $9 million of securities, and sold short an equal amount. The account retains $1 million of the initial investment in cash. EXHIBIT 3.1 Market Neutral Deployment of Capital (Millions of Dollars) Source: Bruce I. Jacobs and Kenneth N. Levy, “The Long and Short on Long-Short,” Journal of Investing (Spring 1997). c03.frm Page 22 Thursday, January 13, 2005 12:10 PM [...]... by the underlying market s return ADVANTAGES OF MARKET NEUTRALITY AND SHORT SELLING Exhibit 3 .2 highlights one obvious benefit of a market neutral equity approach—elimination of market risk In a market neutral portfolio, the returns to active investing are no longer hostage to the sometimes overwhelming effects of broad market moves Of course, this freedom comes at a price: The market neutral portfolio... unique trading requirements of market neutral and to its use of short selling Trading Market Neutral Portfolios The trading of market neutral equity portfolios is more complicated than that of long-only portfolios First, the values and market sensitivities of the aggregate long and aggregate short positions must be kept in balance on a real-time basis in order to provide market neutrality Second, the account... risk We can thus infer that, even though the return on a basic market neutral equity portfolio is neutral to overall equity market movements, market movements can have implications for the implementation of market neutral strategies; in particular, they may necessitate trading activity In practice, of course, one is unlikely to experience market movements of the magnitudes illustrated More likely movements... comparable risk and return, so this is not a benefit unique to long-short.9 Market Neutral Equity Investing 33 The Real Benefits of Market Neutral The real benefits of market neutral emerge only when the portfolio is conceived of and constructed as a single integrated portfolio of long and short positions.10 In this framework, market neutral is not a two-portfolio strategy It is a one-portfolio strategy in... the market neutral manager can submit a package of trades to a broker that guarantees their execution at the market s closing prices Such “principal packages,” which are crossed overseas outside U.S market hours, avoid uptick rules as well as public disclosure of the trades But brokers charge higher fees for principal packages 40 MARKET NEUTRAL STRATEGIES As an alternative to short selling, the market. .. This has prompted a few mutual funds to offer market neutral strategies More taxable investors will now be able to benefit from the added flexibility of market neutral management Such investors should realize that a market neutral portfolio may engage in higher turnover and thus have tax consequences not encountered in long-only Investors should always evaluate strategies net of all costs, whether these... equity risk premium by using derivatives) 26 MARKET NEUTRAL STRATEGIES Another obvious advantage of a market neutral approach to equity investing is that it allows the investor to exploit insights about poor performers as well as good performers Long positions in stocks that are undervalued and short positions in stocks that are overvalued make use of all available market information to enhance returns... much higher for long-only than for market neutral Also, long-short management is almost always offered on a performance-fee basis Regulatory Concerns ERISA’s prudence and diversification requirements are fully consistent with the responsible use of market neutral equity strategies Optimization can control the risk and ensure the proper diversification of portfolios Market Neutral Equity Investing 41 Concerns... the securities to be sold short The result is a single market neutral portfolio, not one long portfolio and one short portfolio Just as one cannot attribute the qualities of water, its wetness say, to its hydrogen or oxygen compo- 34 MARKET NEUTRAL STRATEGIES nents separately, one cannot reasonably dissect the performance of an integrated market neutral portfolio into one element attributable to long... outperformed the longs, the return from the equity portion of the portfolio would be negative.) 24 Hypothetical Performance in Bull and Bear Markets (millions of dollars) Source: Bruce I Jacobs and Kenneth N Levy, “The Long and Short on Long-Short,” Journal of Investing (Spring 1997) EXHIBIT 3 .2 Market Neutral Equity Investing 25 We assume the short rebate (the interest received on the cash proceeds from the short . derivatives. In this sense, market neutral can be said to simplify a plan sponsor’s decision-making. c 02. frm Page 20 Thursday, January 13, 20 05 12: 12 PM CHAPTER 3 21 Market Neutral Equity Investing Bruce. c 02. frm Page 19 Thursday, January 13, 20 05 12: 12 PM 20 MARKET NEUTRAL STRATEGIES Buchan: But the same may not hold if you are considering multiple mar- ket neutral strategies. In general, the value-addeds. incurred. I c03.frm Page 21 Thursday, January 13, 20 05 12: 10 PM 22 MARKET NEUTRAL STRATEGIES MECHANICS Exhibit 3.1 illustrates the operations needed to establish a market neu- tral equity strategy,