Market Neutral Strategies: The Proverbial Free Lunch?

Virginia Reynolds Parker, CFA
President
Parker Global Strategies

Invariably when talking to novice hedge fund investors they express a passion for market neutral strategies, those hedge funds that will pair perfectly with traditional asset classes. The belief that market neutral means risk free underlies their thinking. But a quick reminder that Long Term Capital Management and mortgage arbitrageur David Askin both ran infamous market neutral strategies usually starts them pondering, perhaps at the risk of making them believe that market neutral hedge fund managers belong to a Satanic cult.

Well Which Is It: Saintly or Satanic?

It would be easier to say whether market neutral strategies were Saintly or Satanic if there were a common definition of what market neutral means. But if you ask twenty experienced professionals what market neutral means, you may well get twenty different answers. One pundit has said that market neutral is the "hope and the prayer that markets will remain neutral". A corollary to this thought is that market neutral strategies are subject to fat tail risk, or unpredicted and severe market moves. Other market participants conclude that market neutral strategies are those that don’t depend on market direction as the source of their return. As there are generally three sources of hedge fund returns -- direction, arbitrage and volatility – this definition of market neutral suggests that arbitrage and volatility trading strategies should be incorporated into the definition of market neutral.

Let’s consider a strategy that almost all agree falls under the market neutral moniker: Equity Market Neutral. This strategy exploits pricing inefficiencies between related equity securities, attempting to neutralize exposure to market risk by combining long and short positions. Typically, managers use quantitative models for selecting specific stocks with equal dollar amounts comprising the long and short sides of the portfolio.

Classic equity market neutral seeks to be beta neutral and sector neutral, while at the same time isolating one or more factors from which return can be exploited. While these factors are intentional biases, unintentional biases often emerge as the source of difficulty. In 1999 many equity market neutral managers sustained losses, because their models had positive biases towards value stocks and negative biases towards growth stocks. Whether intentional or unintentional, the bias caused severe damage to many managers. Although never labeled a market neutralist, Julian Robertson of Tiger felt the pain of being a value-oriented investor over the past few years. After being one of the most successful hedge fund managers ever, he shut down in early 2000 due to losses sustained over the past few years as technology/growth price momentum buried investor interest in the grandfather of market discipline, value investing.

I Smell Hell’s Fire Burning

Market neutral strategies can be excellent additions to a portfolio of traditional or alternative investments. However, these strategies do contain risk and each manager’s risk profile is different. The challenge continues to be the analysis of what can go wrong, and how badly an investment portfolio can be hurt. The development of the derivatives market has helped the process of analyzing the discrete risks that form aggregate asset and portfolio risk. The derivatives markets looks at the component parts of asset and portfolio risk: interest rate risk, currency risk, credit or spread risk, specific equity risk, equity market risk, and volatility risk, to name a few. Let’s give some examples of how looking at sources of risk helps answer the Saintly or Satanic question:

Convertible Arbitrage: This strategy involves purchasing a portfolio of convertible securities, generally convertible bonds, and hedging the risk of the embedded equity call option by selling short the underlying common stock. The equity hedge ratio typically ranges from 30 to 100 percent, and individual bond ratings typically range from AA to CCC. Timing may be linked to a specific event relative to the underlying company, or a belief that a relative mispricing exists between the corresponding securities.

Convertible Arbitrage strategies may be hurt when individual portfolio securities experience credit downgrades and their spreads widen, particularly if a manager has a fairly concentrated portfolio. Certain managers hedge this credit default exposure. Yet, even if the default risk for a security has been hedged, there may be a difference between where the bond market and the hedge counterparty have priced the credit default risk. Additionally, market illiquidity can impair performance. The market for convertible securities may be one-sided. As a result, the response to market jolts is usually the drying up of liquidity and deep discounting of prices. This aspect can be particularly deleterious in the burgeoning markets for convertible instruments in emerging markets. Finally, as in any bond investment, interest rate risk exists. Certain managers hedge this exposure.

Fixed Income Arbitrage strategies seek to take advantage of pricing inefficiencies on the spreads of related fixed income securities, while neutralizing exposure to interest rate risk. Strategies may include yield-curve arbitrage, corporate versus Treasury yield spreads, municipal bond versus Treasury yield spreads, or cash versus futures.

In the case of G-10 fixed income arbitrage the price inefficiencies that the fixed income arbitrageur tries to capture are often small. As a result, managers must use a significant amount of leverage to generate return, thereby magnifying risk. In the case of emerging market and high yield fixed income arbitrage, managers may hedge long positions by shorting U.S. or other sovereign debt, leaving the spread risk unhedged. In a liquidity crisis, U.S. treasuries typically rally in a flight to quality while corporate and emerging market spreads widen, resulting in losses on both the long position and the short position. Those managers invested in Russian debt during the 1998 crisis learned a variation on this lesson: a country may elect to default on its sovereign debt. The credit default risk aspect had been ignored by many fixed income arbitrageurs, resulting in significant losses. Even managers who had hedged the default risk found that the contracts they had with hedge counterparties reflected terms and conditions that limited payout in the event of a sovereign default as opposed to a credit deterioration. The hedge contracts proved worthless.

Merger Arbitrage involves investment in event-driven situations such as leveraged buy-outs, mergers and hostile takeovers. Such strategies involve the simultaneous purchase of stock in an acquisition target and the sale of stock in the related acquirer. Some managers may employ equity options as an alternative to the outright purchase or sale of common stock. If the prospective transaction fails to take place, or if the terms of the deal change, managers may experience significant losses. Some managers may short a merger in expectation that such a merger will fail.

Merger Arbitrage strategies are vulnerable to regulatory intervention as well as to the economic/deal flow cycle. Finally, as corporate restructuring has heated up around the globe, the ability of managers to traverse the local and cross-border regulatory, legal and cultural landscape in search of profitable deals becomes more complex adding to transaction risk.

Mortgage-Backed Arbitrage strategies invest in mortgage-backed securities, including government agency, government sponsored enterprise, private-label fixed or adjustable rate pass through securities, fixed or adjustable rate collateralized mortgage obligations, real estate investment conduits and stripped mortgage-backed securities. Managers seek to take advantage of security-specific mispricings.

Mortgage-backed securities contain spread risk as in other fixed income market neutral strategies, but they also contain significant model risk. That is, only a handful of market participants actively trade mortgages, and there are significant differences in their modeling of prepayment risk. As a result pricing discrepancies exist even in the tamest or markets. When market jolts occur, illiquidity and lack of confidence in pricing models conspire to hurt mortgage arbitrage managers. The most important challenge about mortgage securities are their negative convexity. Due to prepayment risk, mortgage instruments eventually fall in price, as treasuries rally. Thus, treasuries, often a favorite hedging instrument for mortgage managers, at times become the enemy.

Multi-Arbitrage investment programs include various arbitrage strategies within the one program. The investment manager allocates among the strategies to seek the best risk/reward relationships. This means that at any given time there will be a mix of risks relating to each of the individual strategies.

Are There Some General Issues to Think About?

As a general rule, market neutral strategies dependent upon fixed income instruments are vulnerable to spread risk. Managers may succeed at neutralizing interest rate risk, but spread risk represents the key driver of returns in tamer markets. A common performance profile of fixed income strategies reflects moderate returns in placid markets and sharp losses in unstable markets when spreads widen and investors seek quality assets.

General economic health helps market neutral strategies. Conversely, economic weakness often hurts many market neutral strategies, because spread risk increases, securities may suffer downgrades, deals may break or overall deal flow dries up. Most deleterious are the sudden shocks such as the short lived global economic crisis that occurred in 1998 as a result of the Russian debt crisis.

Finally, many market neutral strategies may have substantial vulnerability to financing risk. This may be particularly for the more leveraged strategies such as fixed income and mortgage arbitrage. The speed with which prime brokers and other financing sources pull in lines subjectively to protect their own interests against losses during economic crises creates a domino effect of disaster. Unfortunately for most investors, when lines are pulled, these financing sources have key advantages: information, control, and dealing rooms. The larger liquidity providers are in the bird’s eye seat, because they see a substantial amount of the deal flow in the market. The prime brokers control the assets and the financing of those assets. This gives prime brokers the edge of being the first to the door when difficulties hit, while investors often must wait until they can redeem. Understanding the portfolio liquidity of a strategy and the nature of, and contractual obligations of, financing sources becomes especially important in those more leveraged strategies.

Summary

Market neutral strategies are neither saintly nor satanic. They do, however, contain important risks, often influenced by markets. The profile of each strategy and manager must be understood. Not every market neutral strategy reflects the risk profile of an LTCM or Askin Capital, but we often need to use these examples of disaster to warn the naïve and complacent investor that there is no free lunch.

Parker Global Strategies, LLC

Parker Global Strategies is a Manager-of-Managers providing a broad spectrum of Alternative Investment Strategies to private and institutional investors.