Market Neutral: Definition, How Strategy Works, Risk and Benefits

What Is Market Neutral?

A market-neutral strategy is a type of investment strategy undertaken by an investor or an investment manager that seeks to profit from both increasing and decreasing prices in one or more markets while attempting to completely avoid some specific form of market risk.

Market-neutral strategies are often attained by taking matching long and short positions in different stocks to increase the return from making good stock selections and decreasing the return from broad market movements.

Understanding Market Neutral

There is no single accepted method of employing a market-neutral strategy. Beyond the method mentioned above, market-neutral strategists may also use other tools such as merger arbitrage, shorting sectors, and so on.

Managers who hold a market-neutral position are able to exploit any momentum in the market. Hedge funds commonly take a market-neutral position because they are focused on absolute as opposed to relative returns. A market-neutral position may involve taking a 50% long and a 50% short position in a particular industry, such as oil and gas, or taking the same position in the broader market.

Often, market-neutral strategies are likened to long/short equity funds, though they are distinctly different. Long/short funds simply aim to vary their long and short stock exposures across industries, taking advantage of undervalued and overvalued opportunities.

Market-neutral strategies, on the other hand, focus on making concentrated bets based on pricing discrepancies with the main goal of achieving a zero beta versus its appropriate market index to hedge out systematic risk. While market-neutral funds use long and short positions, this fund category's goal is distinctly different from plain long/short funds.

Types of Market-Neutral Strategies

There are two main market-neutral strategies that fund managers employ: fundamental arbitrage and statistical arbitrage. Fundamental market-neutral investors use fundamental analysis, rather than quantitative algorithms, to project a company's path forward and to make trades based on predicted stock price convergences.

Statistical arbitrage market-neutral funds use algorithms and quantitative methods to uncover price discrepancies in stocks based on historical data. Then, based on these quantitative results, the managers will place trades on stocks that are likely to revert to their price means.

A great benefit and advantage of market-neutral funds is their big emphasis on constructing portfolios to mitigate market risk. In times of high market volatility, historical results have shown that market-neutral funds are likely to outperform funds using other certain strategies.

Except for pure short-selling strategies, market-neutral strategies historically have the lowest positive correlations to the market specifically because they place specific bets on stock price convergences while hedging away the general market risk.

Example of a Market Neutral Fund

Because it is a market-neutral strategy, the Vanguard Market Neutral Investor Shares Fund (VMNFX) uses long and short-selling strategies, unlike the firm's other mutual funds, which only buy and sell long positions. The fund's strategy aims to minimize the impact of the stock market on its returns, meaning the fund's returns may vary widely from those of the market.

Although most funds that short stocks, such as hedge funds, do not disclose their short holdings because SEC rules do not require them to, the Vanguard Market Neutral Investor Shares does publish its shorts.

It chooses short positions by evaluating companies in five categories: growth, quality, management decisions, sentiment, and valuation. Then, it creates a composite expected return for all of the stocks in its universe and shorts those with the lowest scores.

Investing in market-neutral specific funds is typically for high-net-worth individuals. For example, VMNFX has a minimum investment amount of $50,000. Other funds may have extremely high expense ratios, well above the investment ratios of passively managed funds.