A brief introduction to market neutral trading from MktNeutral.com with an introduction to zero beta risk management.

1. Jerry Vigil
MktNeutral.com
September 13, 2010
What is market neutral trading?
Market neutral trading or investing is a portfolio management strategy that aims to reduce the risk of a
portfolio to fluctuations in asset prices in the market of a specific group of assets while achieving
positive returns in the portfolio as a whole. In the stock market this is usually achieved by constructing
long-short portfolios by taking long positions in some stocks and short positions in others so that the
correlation of the portfolio’s returns to the return of a particular stock index such as the S&P 500 is close
to zero.
Example: Pairs Trading
Pairs trading is a simple example of market neutral trading. Suppose that a trader would like to take a
position in the telecom sector but would like to reduce her exposure to the overall performance of the
sector because most of the stocks in the sector tend to trade together based on the idea that all of the
underlying companies have exposure to the earnings growth and performance of the telecom industry.
One way to achieve this would be to place a bet on the relative performance of a pair of stocks in the
industry such as Verizon (VZ) and AT&T (T).
Suppose that our trader expects AT&T to outperform Verizon. She may expect this for a multitude of
reason. For example, she may believe that AT&T will take market share away from Verizon because
iPhones are only available on AT&T’s service and she expects many Verizon subscribers to switch to
AT&T so they can use their iPhones. In this case she would take a long position in AT&T and a short
position in Verizon. This pairs trade is not a riskless a position, however, far from it, but it does enable
her to reduce her exposure to the overall performance of the telecom sector.
The risk in this position lies in the relative performance of AT&T versus Verizon. If she were to place half
her money in her long AT&T position and the other half in her short Verizon position, then if AT&T
outperforms Verizon, she will make money, but if Verizon winds up outperforming AT&T, then she will
lose money. However, she could place different portions of her capital in each position.
Zero Beta Risk Management : β = 0
A common method of risk management for market neutral portfolios is called zero beta risk
management. The goal of zero beta risk management is to try and completely eliminate a portfolio’s risk
with respect to the performance of a particular group of assets. In this case our investor would like to
eliminate her risk with respect to the aggregate performance of the telecom sector. She can accomplish
this by weighting her long and short positions such that the beta of her portfolio relative to the
performance of the telecom sector is zero.
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2. Here we speak of the beta from the Capital Assets pricing model (CAPM), which is calculated by
performing a linear regression. I will not go through the details of this computation in this article, but if
you are unfamiliar with CAPM, you can read about it at many places on the web, and a great place to
start is the Wikipedia article (http://en.wikipedia.org/wiki/Capital_asset_pricing_model).
An equally dollar weighted portfolio generally does not have zero correlation to the underlying index
because the components of the index generally do not have the same volatilities. For example, Verizon
has historically been a bit more volatile than AT&T. Thus, if the telecom sector rises sharply she is likely
to lose money in an equal weight portfolio because Verizon will rise more than AT&T because Verizon
trades in a more volatile fashion.
To solve this problem she can compute the beta of each stock with respect to a telecom sector index
such as the Dow Jones US Telecom Index. She will then choose the weights for each position by looking
at the relative size of the betas for each stock. For example, if Verizon has a beta of 1.2 with respect to
the telecom index while AT&T has a beta of 0.8, then she would place 60% of her capital in her long
AT&T position and 40% of her capital in her short Verizon position. This follows from solving the set of
simultaneous equations below:
WT + WVZ = 1
WTβT + WVZ βVZ = 0
where WT, WVZ, βT, βVZ are the portfolio weights for AT&T and Verizon and their corresponding
betas, respectively.
This analysis can be extended to more complex portfolios consisting of more than two stocks.
One important thing to consider, however, is that the betas used in this analysis are usually the
historical values for the beta and not the future values. The beta of a stock is not a static value
but rather, dynamic just as the stock’s price and can change wildly over time. Thus, this analysis
leaves one with the problem of predicting the future values of beta. Using the historical value
of beta is often a great place to start, but there is no guarantee the future beta will be close to
the historical value.
Market Neutral Portfolios
A portfolio is referred to as “market neutral” with respect to an index if its beta is zero with
respect to that index and such portfolios are called market neutral portfolios. Market neutral
portfolios are not without risk, but they aim to eliminate risk with respect to a certain market,
which in our example, is the portfolio’s risk with respect to the performance of the telecom
sector as a whole.
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3. In the hedge fund industry there is an entire group of strategies and funds that fall under the
market neutral category, each of which aims to reduce risk. Pairs trading individual stocks, long
short sector rotation, long short countries, and merger risk arbitrage are common examples.
While not all of these funds use zero beta risk management, research indicates that they have
the lowest beta of all of the major groups of hedge funds except for short hedge funds which
have a negative beta.
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