Market neutral strategy
What is Market neutral strategy?
Market neutral strategy or Long/short equity is an investing strategy of taking long positions in stocks that are expected to appreciate and short positions in stocks that are expected to decline. A long/short equity strategy seeks to minimize market exposure, while profiting from stock gains in the long positions and price declines in the short positions. Although this may not always be the case, the strategy would be profitable on a net basis as long as the long positions generate more profit than the short positions, or the other way around. The long/short equity strategy is popular with hedge funds, many of which employ a market-neutral strategy where the dollar amounts of the long and short positions are equal.
BREAKING DOWN 'Long/Short Equity'
While many hedge funds also employ a long/short equity strategy with a long bias (such as 130/30, where long exposure is 130% and short exposure is 30%), comparatively fewer hedge funds employ a short bias to their long/short strategy.
Long/short equity strategies can be differentiated in a number of ways – by market geography (advanced economies, emerging markets, Europe, etc.), sector (energy, technology, etc.), investment philosophy (value or growth) and so on. An example of a long/short equity strategy with a broad mandate would be a global equity growth fund; an example of a relatively narrow mandate would be an emerging markets healthcare fund.
A popular variation of the long/short model is that of the “pair trade," which involves offsetting a long position on a stock with a short position on another stock in the same sector. For example, an investor in the technology space may take a long position in Microsoft and offset that with a short position in Intel. If the investor buys 1,000 shares of Microsoft at $33 each, and Intel is trading at $22, the short leg of this paired trade would involve purchasing 1,500 Intel shares so that the dollar amounts of the long and short positions are equal.
The ideal situation for this long/short strategy would be for Microsoft to appreciate and for Intel to decline. If Microsoft rises to $35 and Intel falls to $21, the overall profit on this strategy would be $3,500. Even if Intel advances to $23 – since the same factors typically drive stocks up or down in a specific sector – the strategy would still be profitable at $500, although much less so.
To get around the fact that stocks within a sector generally tend to move up or down in unison, long/short strategies frequently tend to use different sectors for the long and short legs. For example, if interest rates are rising, a hedge fund may short interest-sensitive sectors such as utilities, and go long on defensive sectors such as health care.
