Market Neutral Strategies

Market Neutral Strategies

With a Foreword by Mark Anson, Ph.D.,
Chief Investment Officer, CalPERS

Synopsis

As the co-founders and principals of Jacobs Levy Equity Management, Bruce Jacobs and Ken Levy have been designing, managing, and writing about market neutral equity strategies since 1990. Market Neutral Strategies provides a forum in which they and some of the industry's other leading market neutral practitioners discuss the implementation, the benefits, and the risks of market neutral investing. The discussion is directed toward institutional investors, sophisticated individual investors, and investment consultants who seek a deeper understanding of how these strategies can contribute to the pursuit of investment return and the control of investment risk.

In general, market neutral strategies seek to profit from detecting perceived mispricings in individual securities and constructing portfolios that deliver the excess return (and risk) associated with those securities, regardless of underlying market moves. This is accomplished by holding balanced long and short positions in various securities and/or by holding these securities in conjunction with long or short positions in derivatives securities so that the overall portfolio's exposure to primary risk factors such as equity market and interest rate risks is neutralized. Market neutral investing employs the same instruments as more conventional strategies, although it tends to be more dependent on derivatives than conventional strategies. Market neutral investing also exploits the same methods as more conventional active strategies, including in-depth fundamental analysis, technical approaches, and quantitative valuation and construction techniques. Market neutral strategies have the same basic aim as more conventional active strategies: to buy low and sell high. In more traditional approaches, however, the buying and selling are sequential events, whereas in market neutral they are more often concurrent.

Market Neutral Strategies covers five popular strategies. In "Market Neutral Equity Investing," Bruce Jacobs and Ken Levy demonstrate the construction and benefits of an optimal, integrated market neutral portfolio using long and short positions in individual equity securities. In "Convertible Bond Hedging," Jane Buchan of Pacific Asset Management Company examines a market neutral strategy that seeks to profit from the premium offered by convertibles over either their bond or stock equivalent values, while hedging associated equity market and interest rate risk. John Maltby of DKR Capital, in "Sovereign Fixed-Income Arbitrage," details two strategies for building market neutral portfolios with national debt securities; one involves bond futures and the other interest rate swaps. Among the more complicated and esoteric market neutral strategies is mortgage arbitrage. "Market Neutral Strategies with Mortgage-Backed Securities" by George E. Hall of the Clinton Group and Seth C. Fischoff gets into the meat and potatoes of these portfolios, including such issues as how to deal with prepayment risk and "burnout." Daniel S. Och of Och-Ziff Capital Management and Todd C. Pulvino of Northwestern University's Kellogg School of Management, in their chapter "Merger Arbitrage," show how merger arbitragers can reap an "insurance premium" by taking on the risk of merger failures.

Additional chapters cover areas of general concern. Jane Buchan joins editors Bruce Jacobs and Ken Levy to answer some common questions in "Questions and Answers About Market Neutral Investing." For instance, can neutrality be achieved by combining a portfolio holding long positions with one holding short positions? Aren't short positions inherently riskier than long positions? Should an investor use a single manager or multiple managers to best exploit market neutral strategies? In "Transporting Alpha," Bruce Jacobs and Ken Levy show how the excess alpha return from a market neutral strategy can be combined with the systematic return on virtually any asset class, offering plan sponsors and investment managers the ability to optimize the returns from both asset allocation and security selection. Bruce Jacobs and Ken Levy go on to examine two notorious "market neutral" failures, dissecting the cases of Askin Capital Management, a firm that specialized in mortgage arbitrage, and Long-Term Capital Management, which dealt in sovereign fixed-income, merger arbitrage, and equity option and long-short trading; these two cases provide some object lessons for investors considering market neutral managers. Investors and managers alike may gain much needed insight into the taxation of market neutral investing from "Significant Tax Considerations for Taxable Investors in Market Neutral Strategies" by Peter E. Pront and John E. Tavss of Seward & Kissel. Seward & Kissel's Peter Pront and S. John Ryan follow up with a look at some tax and legal concerns for tax-exempt investors in market neutral strategies in "Tax-Exempt Organizations and Other Special Categories of Investors."

Their potential contribution to overall fund diversification has been one of the primary selling points for market neutral strategies. These strategies have much to offer beyond diversification, however. They can be used, for example, to exploit opportunities in markets that might otherwise be considered too risky for suitable investment. They can allow investors to fine-tune portfolio risk exposures. They can also be used to enhance return; the ability to sell short, for example, allows the investor to seek out opportunities in overvalued securities, as well as undervalued ones. And, one of the major advantages of market neutral construction is that it allows the investor to extract the return available from selecting securities in one asset class and, by using derivatives, to transport that return to an entirely different asset class, allowing the investor to reap the rewards of both individual security selection and asset class selection.