Handbook of Hedge Funds

9

Equity Market Neutral

An investment process based on a quantitative model is not a black box, but an investment process based on subjective assessments and gut feeling is!

Most long/short equity managers select stocks separately for the long and the short sides of their portfolio. They pay little attention to the relation between their long and their short positions, or more generally, to their portfolio construction process. Consequently, their funds often have a net long or a net short exposure, depending on the set of available opportunities and the manager’s outlook for the near term direction of the overall market. In either case, their portfolio performance becomes dependent upon directional market movements. Alfred W. Jones’ fund, for instance, had a tilt towards long positions – his shorts were of a generally smaller magnitude than his longs.

The goal of equity market neutral managers is precisely to avoid any net market exposure in their portfolio. Selling and buying are no longer sequential independent activities; they become related and in some cases even concurrent. In addition, long and short positions are regularly balanced to remain market neutral at all times, so that all of the portfolio’s return is derived purely from stock selection and no longer from market conditions. This explains why many investors perceive equity market neutral as the quintessential hedge fund strategy. Indeed, when correctly implemented, it offers the promise of true absolute returns ...