Stockholm (HedgeNordic) – In the dynamic world of investing, where volatility and uncertainty are ever-present, strategies that can deliver consistent returns while mitigating market risk remain a top priority for investors. Among the approaches that have emerged, market-neutral equity strategies have gained recognition for their ability to navigate turbulent markets and potentially enhance portfolio performance.

The performance of market-neutral equity funds in difficult market conditions is worth noting. In 2022, the ten market-neutral equity funds included in the Nordic Hedge Index achieved an average gain of 1.6 percent, while broader equity markets experienced double-digit declines. And yet, the performance of a broader market “is not a relevant comparison for a market-neutral strategy,” argues Jakob Nordestedt, who runs a market-neutral strategy under the umbrella of Nordea Asset Management. “If investors would evaluate us like this, they would think I am doing something poorly when the market goes up and that I am a genius when the market goes down.”

Instead, market-neutral equity managers should be judged by their ability to generate uncorrelated returns through their stock picking skills. “If a market neutral portfolio is run in a correct way, with zero market correlation, its performance will only be determined by the stock picking skills of your portfolio manager,” considers Nordestedt. The true value of a well-designed market-neutral strategy lies in its ability to provide an uncorrelated return stream and “act as a risk-balancing tool against undesirable market movements.”

“If a market neutral portfolio is run in a correct way, with zero market correlation, its performance will only be determined by the stock picking skills of your portfolio manager.”

Simon Røksund Johannessen, a portfolio manager overseeing an energy-focused market-neutral equity fund at Norwegian pension provider KLP, shares Nordestedt’s viewpoint. “Market-neutral equity strategies are designed to deliver returns that are independent of the direction of the overall market,” highlights Johannessen. These strategies eliminate the need for the broader market to move in a particular direction to generate returns. “The primary benefits of market-neutral strategies are that they can reduce portfolio volatility and offer a source of returns uncorrelated with the rest of the market.”

“The primary benefits of market-neutral strategies are that they can reduce portfolio volatility and offer a source of returns uncorrelated with the rest of the market.”

Johannessen also emphasizes the importance of considering market-neutral strategies as a means of reducing systematic market risk in a portfolio. However, he underscores that the strategy must generate alpha, which is achieved through isolating stock-specific risk and focusing on individual opportunities rather than broad market exposure. “Of course, the strategy needs to generate alpha,” emphasizes the portfolio manager of KLP Alfa Global Energi. Nordestedt concurs, stating that “all our returns are and should be coming from alpha generation.”

Nordestedt further explains that “the return of a market-neutral strategy should always be viewed as the risk-free interest rate plus the return of the active portfolio.” He highlights the need for a market-neutral strategy to have zero impact from economic factors. “We take this very seriously and run the book with a net exposure of 0 at all times,” says Nordestedt. “In addition, we implement a style factor hedge in order to be neutral to any economic factor, market rotations or whatever may be out there.” The goal, at the end of the day, is to generate returns solely from alpha sources rather than beta exposure.

Misconceptions

Despite the appeal of equity market-neutral strategies, several misconceptions surround them, often leading to confusion and skepticism among investors. “The most common misconception among investors must be that there should be some sort of market correlation,” argues Jakob Nordestedt. He has sought to solve this misconception by building a fund that is truly market neutral. “If a market-neutral fund is structured correctly, it will have no correlation at all to the market.”

“If a market-neutral fund is structured correctly, it will have no correlation at all to the market.”

Another misconception, according to Johannessen, is that equity market-neutral strategies offer risk-free or guaranteed returns. “Market-neutral strategies are not risk-free. Investors need to understand these risks when considering market-neutral strategies,” explains the portfolio manager of KLP Alfa Global Energi. The market-neutral fund specializing in the energy sector has enjoyed exceptional performance in recent years, atypical for a market-neutral fund. KLP Alfa Global Energi generated an annualized return of 15.3 percent in the three years ending April 2023 to reach a three-year Sharpe ratio of 1.9. While such performance is “unexpected and not normal,” this feat is not unachievable going forward.

“Market-neutral strategies are not risk-free…”

How to Choose a Market-Neutral Strategy

Based on his experience as a market-neutral investor, Johannessen puts forward a three-step rule to analyzing and selecting a market-neutral strategy. “First, understand the strategy and what kind of unique alpha the fund manager provides,” starts Johannessen. “Second, consider the track record of the manager and under what market conditions his strategy has worked,” he continues. “Third, get a good understanding of what kind of risk has been used to generate the returns in the manager’s portfolio.”

“…understand the strategy and what kind of unique alpha the fund manager provides.”

Nordestedt offers a similar suggestion but emphasizes the importance of focusing on the “process” during due diligence. “Having done this for some time, I would do deep due diligence but only focus on one thing: process,” starts Nordestedt. “One of the most important things is to understand the stock picking process and how it can be repeated over and over again. This is much more complicated than most would believe,” he emphasizes. The second process that needs to be understood is the portfolio construction and risk framework, according to Nordestedt. “This is more important than the stock picking as this is where you are facing much more systematic risk than a bad case in a stock,” highlights Nordestedt. He believes that the funds excelling in both of these processes will be the long-term winners.

Equity market-neutral strategies are a type of hedge fund strategy that allows investors to actively position their portfolios while limiting exposure to market risk. While there is no prescribed approach or strict definition for these strategies, they tend to be inherently defensive in nature. Market-neutral strategies may underperform broad market indices during bullish periods but can offer valuable downside protection during market downturns, and dampen volatility when added to a broader portfolio. Thoroughly evaluating the strategy’s unique alpha, track record, risk framework, and investment process will be crucial in identifying strategies that can generate consistent returns while effectively managing market risk.