Compared to a long or short portfolio that seeks relative returns (relative to the benchmark), a market neutral strategy combines long and short positions and aims to generate absolute returns—regardless of the general direction of the market. The risk exposure of long and short positions is equal, so in the event of a general market decline, the losses of the longs will be offset by the gains of the shorts, and vice versa.
At this point, you may be asking, no matter which direction the market goes, how will the returns be generated if the gains and losses are offset? This is where stock picking comes into play. While market risk has been spread out, it is entirely possible for a long or short position to outperform and thus generate returns.
Another benefit of a market-neutral strategy is that such a strategy allows for more freedom than traditional long-term investing. Traditional long investors cannot take any short positions, even when the market slumps. They can't get any returns from stocks they think are about to fall. However, investors with a market-neutral strategy can combine long positions in stocks that are expected to outperform with short positions in overvalued companies, potentially improving returns, especially if both bets pay off.
A market-neutral strategy is an excellent way to reduce portfolio volatility and present a good risk-reward. However, it remains directionless. This means that one cannot profit from a general rise in asset prices in a rapidly rising market, nor can one benefit from a net short portfolio in a rapidly falling market. In fact, in rapidly changing directional markets, asset prices tend to have higher correlations as people become extreme risk-seeking or risk-averse. This means that the spread between the best and worst performing stocks is tighter and can lead to lower returns from market neutral strategies.
Investors who use market-neutral strategies in volatile markets aim not at maximizing returns, but stabilizing and hedging risk. The downside of a market-neutral strategy is also clear: in a rising market, one misses out on the potential gains from a general rise in asset prices, which are likely to be greater than the absolute gains from differences in individual price movements.
A competent portfolio manager cannot be satisfied with a single strategy. It makes sense to use a market-neutral strategy for only a portion of a portfolio, such as in a core-satellite portfolio, as a way to boost returns compared to other long-term, passive portfolios. It is also entirely reasonable, perhaps even sensible, for portfolio managers to adjust their approach to current market conditions, using market-neutral strategies only when deemed favorable.
In conclusion, market neutrality can be a great tool for any portfolio manager. It further increases the level of diversification and greatly reduces the market risk of the portfolio. It can be used both to reduce overall portfolio volatility and to maximize returns by shorting underperforming companies and longing outperforming companies.
