Statistical Arbitrage and Other
Market Neutral Trading Strategies

Explained:

alpha transport

capital structure arbitrage

convertible arbitrage

equity market neutral

fixed income arbitrage

market neutral strategy

pairs trading

relative value strategy

statistical arbitrage

 
   

Market neutral strategies are trading strategies that are widely used by hedge funds or proprietary traders. A trader goes long certain instruments while shorting others in such a way that his portfolio has no net exposure to broad market moves. The goal is to profit from relative mispricings between related instruments—going long those that are perceived to be underpriced while going short those that are perceived to be overpriced—while avoiding systematic risk. Market neutral strategies are sometimes called relative value strategies.

In equity markets, market neutral strategies take two forms.

equity market neutral, and

statistical arbitrage.

The former is a strategy that emphasizes fundamental stock picking. A portfolio of long and short positions is maintained to be beta neutral. If the portfolio holds foreign equities, foreign exchange risk will generally also be hedged away. Long and short positions are also managed to eliminate net industry, market capitalization, regional or other exposures.

   

Statistical arbitrage—or stat arb—is an equity trading strategy that employs time series methods to identify relative mispricings between stocks. One technique is pairs trading. Pairs of stocks whose prices tend to move together—i.e. they are cointegrated—are identified. If the historical price relationship between them is ever violated, a long-short position is established in the two stocks in anticipation of the relationship being reestablished. The rationale is that the abnormal price move was a liquidity effect caused by a large buy or sell order for that stock, and it will reverse over time. Individual pairs will generally not be market neutral, but the overall portfolio of pairs can be managed to be market neutral. However, the focus is more short-term than equity market neutral. Exposures to factors such as industry or market capitalization may not be as tightly controlled. Pairs trading can be extended in various ways, for example, by identifying and trading larger baskets of cointegrated stocks.

Various risk neutral strategies are employed in fixed income markets. All are collectively called fixed income arbitrage and entail identifying and exploiting inconsistencies in the numerous term structures, liquidity spreads and credit spreads found in fixed income markets around the world. These may involve

   

term structure trades—say borrowing at the short end of the spot curve and lending at the long end,

credit spread trades—perhaps buying a bond with poor credit quality and shorting another that is a better credit.

liquidity trades—which might entail holding an illiquid instrument but financing it with liquid debt, and

cross market trades—which have long-short positions spanning different markets or economies.

Fixed income arbitragers try to identify when historical patterns for spreads or term structure relationships have been violated and put on a long-short position in anticipation of the historical relationship being reestablished. They also look for situations where credit risk or liquidity risk is being over compensated and will then put on a long-short position that earns positive carry. Central bank intervention in the markets often creates abnormalities that can be exploited.

Fixed income arbitrage strategies are generally implemented to be duration neutral, but they are exposed to various other market risks. By their nature, particular strategies may be exposed to tilts in the term structure, spread risk and foreign exchange risk.

Capital structure arbitrage seeks to profit from inconsistencies in the relative pricing of a firm's debt and equity. Hybrid instruments, which span both debt and equity markets, play a key role in these strategies. Convertible arbitrage exploits mispricings of a firm's convertible bonds. Convertible bonds have complex exposures to interest rates, the issuer's credit quality, liquidity spreads, the issuer's stock price, and implied volatility. This makes them extremely difficult to price. Hedge funds develop sophisticated pricing methodologies and go long or short convertible bonds they perceive to be mispriced. To maintain market neutrality, they will generally hedge the position with positions in the issuer's debt and/or equity. Other hybrids, such as equity default swaps, offer more opportunities.

 

Event driven trading strategies are generally considered a separate class of trading strategies from market neutral strategies, but many are implemented to be market neutral.

Market neutral strategies tend to be self-financing, with cash from short sales financing long positions. This facilitates a practice known as alpha transport. Consider a pension plan that has an actively managed portfolio of US equities. It can achieve the same thing by investing in a US equity index fund and hiring a hedge fund to implement a self-financing market neutral strategy in US equities. Instead of having one actively managed portfolio generating both alpha and beta, alpha would be obtained from the hedge fund, and beta would be obtained from the index fund. This raises an interesting issue. The US equity market is highly efficient. The pension plan wants to earn US equity returns, but US equities are not the best market in which to seek alpha. A better strategy might be to invest in a US equity index fund but then hire a hedge fund to implement a market neutral strategy in some other market that is less efficient and, hence, offers greater opportunity to generate alpha. The pension plan would still obtain beta from the index fund and alpha from the hedge fund, but now the hedge fund would be sourcing the alpha in a more attractive market. In effect, the pension plan would be "transporting" alpha from one market to another.

Market neutral strategies often employ derivatives. Futures or swaps are convenient tools for adjusting a portfolio's broad market exposure to be market neutral. Derivatives also might be used to exploit perceived mispricings between instruments and derivatives that have those instruments as underliers.

Market neutral strategies are controversial because they tend to be highly leveraged, are inherently speculative, and are in conflict with the efficient market hypothesis. Proponents argue that the strategies can be safely implemented with suitable risk management. Also, with alpha transport, they can be implemented in emerging or illiquid markets that would not be expected to be efficient. Event driven strategies are implemented in unique situations—such as mergers or divestitures—where market efficiency may temporarily break down.

As a practical matter, true market neutrality is difficult to achieve. During periods of turmoil, markets tend to become highly correlated. Although a market neutral strategy may entail no direct exposure to a given market, it can still be indirectly exposed to that market through other factors that become correlated with the market during periods of turmoil. An example is fixed income arbitrage that seeks to exploit excessive liquidity spreads. In a market crash, those liquidity spreads will widen, causing the strategy to lose money as the market falls. Because of such second-order exposures, market neutral strategies tend to consistently make money in normal market conditions but suffer large losses during market crashes. Most have negatively skewed, leptokurtic return distributions and have been likened to picking up nickels in front of a steamroller. Stated in more economic terms, market neutral strategies tend to earn money by providing liquidity to the market. They can lose money when they provide that liquidity at an inopportune time.

Related Books

       

Related Internal Links

active investing An approach to managing a portfolio that entails trading for the purpose of enhancing returns.

alpha If active investment management were a religion, alpha would be its god.

arbitrage A transaction which generates a risk-free profit.

beta A metric of the systematic risk of a portfolio.

convertible security A hybrid security that can or must be exchanged for some other security, usually the issuer's common stock.

directional strategy A trading or investment strategy that entails taking net long or short positions in a market.

event driven strategy Speculative trading strategy that seeks to exploit relative mispricings between securities whose issuers are involved in mergers, divestures, restructurings or other corporate events.

hedge fund A largely unregulated investment fund that specializes in taking leveraged speculative positions.

leverage Debt financing or anything that can similarly magnify the risk and reward of an investment.

liquidity Term used in various senses, all relating to availability of, access to, or convertibility into cash.

liquidity risk Risk due to uncertain liquidity.

market risk Exposure to the uncertain market value of a portfolio.

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Related Forum Discussions

Hedging Convertibles with Index Futures? 19 Feb 2003
Realities of hedging a complex exposure.

VaR for Statistical Arbitrage 15 Aug 2002
Lengthy discussion of pairs trading.

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