A rationale for equity market neutral strategies

Stockholm (HedgeNordic) – The phrase ‘this time is different’ has been described as the four most expensive words an investor can utter. It is also the first part of a title of a best-selling book, the remainder being ‘eight centuries of financial folly’1. The authors state that, throughout history, countries have been lending, borrowing, crashing into financial crises and recovering. On each occasion, experts claim that the old rules of valuation and portfolio construction no longer apply – only to be proven hopelessly wrong.

Since the late 1950s, if not earlier, bonds have proved the core holding for the majority of institutional investment portfolios. Equities were considered more volatile than bonds, with some justification, and we became accustomed to the idea that bonds typically yield more than equities. So, the solution to the investment conundrum seemed obvious – invest in bonds and sleep easy! However bonds have now been in a secular bull  market for more than three decades, pushing yields to new lows at a time of rising aggregate debt levels. Low interest rates have also made it possible for corporations to avoid potential default by refinancing on favourable terms (‘amend and extend’).

Consequently, it is reasonable to question whether the risk/reward asymmetry of investing in bonds has now become skewed to an extent that it really is different from anything we have seen before; we have no precedent for a ‘bond bubble’ driven by a massive expansion of central bank balance sheets, which has coincided with spiralling government indebtedness.

As academic researchers take pains to point out, there is no absolute limit for total indebtedness or a certain percentage of debt-to-GDP where the structure of debt markets begins to break down. The system is based on trust and confidence, so it will work until it doesn’t – and then things could get really messy if everybody tries to head for the exit simultaneously. The challenge is, therefore, to provide an alternative solution to a bond allocation, which can act as a partial substitute within a portfolio context. This bond proxy clearly needs to possess the attributes that are readily associated with bonds, such as positive return expectations, limited volatility and a low correlation to equity markets. The solution will also need to have a low correlation to bond markets, if it is to diversify and mitigate the prospective market-event risks that could potentially arise across the fixed-income spectrum. So, like bonds and yet, not bonds!

To read the whole interview in the HedgeNordic Special Report on market neutral strategies, please click here: Market Neutral Strategies 

Picture: (c) Hirurg—shutterstock.com

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