As shown in Figure 1, from January 1997 to August 2015, market neutral strategies had only a 0.18 correlation to equities and a 0.04 correlation to bonds. Market neutral also had low correlation to another popular asset class, commodities, as well as to other segments of the fixed income market, such as leveraged loans and high yield. As investors seek to diversify their holdings in order to lower overall volatility, we believe market neutral strategies should be considered as a way to achieve that goal.
2. They may offer lower levels of total volatility
Another way to potentially mitigate risk across an investment lineup is to include strategies that may offer lower levels of total volatility (variation in portfolio returns). Even if these strategies were perfectly correlated with other investments, their potentially lower total volatility profile could help lower the overall average volatility of the full lineup. Market neutral strategies also may be appealing to investors from this total volatility perspective, as their volatility has tended to be less than the broader equity markets, and in some cases, similar to broad fixed income indexes (see Figure 2). Furthermore, since market neutral returns are expected to be independent of the broader equity market, a spike in market-level volatility may not necessarily mean a spike in market neutral volatility.
3. They have a history of attractive downside protection during extreme market stress
Another often-cited potential benefit of market neutral is that the strategies may offer investors a way to mitigate severe losses during a sharp equity market sell-off. Because these strategies typically have beta exposure to the market that hovers around zero, a big drop (or surge) in equities should not influence the performance of the strategy. This contrasts sharply with traditional, benchmark-centric strategies, which typically have very high levels of market exposure and tend to vary similarly to the broader market.
4. They can provide an opportunity for higher returns in a rising interest rate environment.
We believe an increase in the federal funds rate from the US Federal Reserve is inevitable; at this point it’s simply a matter of when and by how much. For market neutral equity strategies, a rise in interest rates – specifically short-term interest rates — can potentially provide a boost to returns. This occurs when market neutral equity strategies short a stock and receive proceeds from that sale. Those proceeds typically earn a rate of return tied to the prevailing short-term interest rate, such as the fed funds rate. When that rate increases, so does the interest earned by market neutral equity strategies on their short sale proceeds
Key takeaway
We believe a market neutral equity strategy is a valuable complement to a traditional portfolio of stocks and bonds, as well as an excellent diversification tool that enables investors to pursue increased returns from assets that respond differently to changing market conditions. Such characteristics may be important to today’s investors given the recent market downturn, volatility and expectation of rising interest rates.