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 under priced
while going short those that are perceived to be over priced—while
neutral strategies are sometimes called
relative value strategies.
In equity markets, market neutral strategies take two
market neutral, and
The former is a strategy that emphasizes fundamental
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
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
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 caused by an investor trading on spurious information.
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
and credit spreads
found in fixed income markets around the world. These may involve
structure trades—say borrowing at the short end of the spot curve and
lending at the long end,
spread trades—perhaps buying a
bond with poor
credit quality and shorting
another that is a better credit.
trades—which might entail holding an illiquid instrument but financing it
with liquid debt, and
market trades—which have long-short positions spanning different markets
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
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
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
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
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
return distributions and have been
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
A transaction which generates a risk-free profit.
measure of the systematic risk of a portfolio.
A hybrid security that can or must be exchanged for some other security, usually
the issuer's common stock.
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.
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.
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.
is an outstanding book on trading in general. Calamos (2003)
is an excellent book on convertible arbitrage.
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