Tips For Investing in Market Neutral Markets
A market neutral strategy is an investment style that aims to minimize or even eliminate any market risk. In practice, such an approach involves hedging against market risks. To evaluate market neutrality, investors must specify the risk they seek to avoid. Here are some examples:
Portfolios with zero beta are not market neutral
Market-neutral portfolios eliminate the beta factor. Beta is a measure of how closely a company’s movement resembles its benchmark. For example, if the beta of a stock is two, it will move twice as fast as the S&P 500. But a market-neutral portfolio has a beta of zero, meaning that it should not have a significant correlation with the benchmark.
Market-neutral strategies diversify from traditional asset classes. They can cushion severe declines in equity markets, dampen overall volatility, and even enhance the return of rising interest rates. But they are not completely risk-free. Depending on the strategy you choose, you may suffer a substantial loss during a bear market. Therefore, it’s important to understand the difference between a market-neutral portfolio and a traditional benchmark-centric strategy.
Fundamental arbitrage vs statistical arbitrage
In trading, one should focus on one or two strategies, such as technical analysis or fundamental analysis, to ensure that their investments are not subject to over-reactions or unfavorable market trends. Using multiple strategies at once increases the risk of making mistakes. Technical and fundamental arbitrage are both easy to use, and both have their benefits and disadvantages. This article discusses the main differences between these two trading strategies.
While both are based on statistical data, statistical arbitrage involves trading two different assets in opposite directions. For example, a 4% drop in crude oil will impact two companies, which are linked by their underlying assets. Statistical arbitrage identifies such a unique correlation and uses it to open opposing trades. The strategy works on the idea that two stocks that move in opposite directions will tend to follow each other.
While the high turnover in market-neutral portfolios is generally acceptable, the lack of systematic risk in these assets makes them less attractive to many investors. In the end, this type of portfolio represents the most efficient risk-return asset. If you don’t have access to financial advisers, it’s worth your time to find one and learn more about this kind of investment strategy. Here are some tips for investing in market-neutral markets.
One benefit of investing in market-neutral funds is that the risk of losing money is significantly lower than in other asset classes. Market-neutral funds are very good diversifiers in equity-dominated portfolios. However, recent low returns from Market Neutral funds are attributed to poor performance of Value and Alternative Risk Premia Factor strategies. Consequently, high turnover in market-neutral funds has contributed to the low performance of this asset class.
Positive absolute returns
A market-neutral strategy is a portfolio that provides positive absolute returns regardless of market direction. Market-neutral strategies generally have very little exposure to specific forms of risk, such as market declines or gains. A portfolio manager may use various investments to hedge against specific risks, or choose to remain exposed to more idiosyncratic risks such as company-specific risks, such as those related to interest rates.
An investor using an absolute-return strategy aims to earn a certain target return, which is often a multiple of risk-free interest rates. In addition, such a fund cannot take a significant fixed position in the market. Similarly, it likely puts a high emphasis on risk-control and diversification. Positive absolute returns in a neutral market can be a good fit for someone who doesn’t want to trade in the market very often.
Resilience to sudden changes in liquidity
The current state of market liquidity has implications for the resilience of markets to sudden change. There are three broad categories of variables influencing the level of market liquidity. These variables include risk appetite, funding constraints, and market risks. Among them, the risk appetite of financial intermediaries influences the speed of asset-price discovery by buyers and sellers. In addition, search costs affect the speed at which buyers and sellers are able to locate each other. Moreover, the characteristics of investors influence the speed at which they can find the other.
Resilience to sudden changes in liquidity is characterized by its ability to withstand a shock. If liquidity is resilient, it will withstand the shock and bounce back after the event, while non-resilient liquidity will spike up following a shock. Moreover, the model can disentangle the direction of causality among the variables. It also provides evidence that the levels of liquidity are closely linked. As a result, even seemingly sound markets can be subject to evaporation.