Market Neutral Investing in a New Regime

Key points

As macroeconomic uncertainty persists, investors may want to consider complementing traditional asset classes with additional sources of diversification and return.
Market-neutral strategies may help to improve portfolio outcomes by expanding the investment opportunity set, taking advantage of heightened security dispersion, and providing a diversifying return stream with a low correlation to broad asset classes.
Systematic processes may maximize the effectiveness of market-neutral investing—enabling a granular and nimble approach to investment analysis and implementation.

Macroeconomic uncertainty has remained front and center in 2023 as the new investment regime continues to play out. Inflation remains above central bank targets and some signs of economic weakness have started to surface in the wake of rapid monetary tightening. The dynamics of stable growth, low rates, and low inflation that persisted in recent decades are now working in reverse, creating a new era of increased market volatility.

The previous macroeconomic regime known as the Great Moderation generally supported stable returns and reliably low correlations between stocks and bonds—making the traditional 60/40 allocation¹ an ideal asset mix for many investors. Now, investors may need to rethink portfolio construction by complementing traditional asset classes with new sources of diversification and return. While there’s no one-size-fits-all solution, market-neutral strategies may help to improve portfolio outcomes by offering a diversifying return stream with a low correlation to broad asset classes.

What is market-neutral investing?

As the name suggests, market-neutral strategies are designed to target returns that are independent of market direction. Compared to active long-only strategies that invest only in the highest conviction stocks and avoid those with a less favorable outlook, market-neutral strategies are able to make both long and short investments.² As shown in Figure 1, this expands the opportunity set for return generation, allowing investors to express a broader range of active views (positive, less positive, or negative) across each stock in the investment universe.

A relatively even split of long and short investments results in a net market exposure of zero. This greatly reduces the influence of market fluctuations on the strategy’s returns. Instead, returns are driven by security selection and the ability to effectively forecast the relative return differential between long and short holdings.

In practice, if the short side of the portfolio lags the long side of the portfolio (in line with forecasts), then those positions will contribute to the strategy’s return potential regardless of market direction. Figure 2 illustrates this concept in the event that markets are trending upward. If Holding A is projected to increase by 12% and Holding B is projected to increase by 2%, an investor would buy A and short-sell B to target an expected return of 10% (before factoring in transaction costs) without exposure to the overall market.

When are market-neutral strategies expected to perform best?

The spread in performance between long and short positions is where the alpha³ opportunity exists for market-neutral strategies. This means that the more variation there is in performance across securities, the richer the opportunity set is for return generation.

In recent decades, an abundance of central bank liquidity and low borrowing costs supported stable returns for most assets and suppressed security dispersion—or the degree of difference in performance across single securities. Now, macro volatility is creating a more dispersed market environment as individual companies differ in their ability to adapt to challenges like persistent inflation and higher interest rates.

Dispersion is a return source that’s not captured in the traditional 60/40 construct. While stock and bond returns are highly dependent on economic and market conditions, the dispersion can exist regardless of market direction. Importantly, it tends to be the highest when markets are volatile and uncertain—the very time that 60/40 portfolios need the most help. Figure 3 shows how equity return dispersion has risen above its historical average. As the previous ‘rising tide lifts all boats’ environment appears to have come to an end, the opportunity to take advantage of the relative return differences across securities makes a market-neutral approach increasingly compelling.

How can market-neutral strategies improve portfolio outcomes?

Macro volatility has also shifted the diversification properties of 60/40 portfolios that have been foundational to portfolio construction in recent decades. During the Great Moderation, below-target inflation gave central banks the freedom to cut interest rates and ease financial conditions in response to growth shocks. This meant that when stocks would fall, interest rate cuts generally caused bonds to rally and provide a ballast against equity risk.

Now, central banks are limited in their ability to cut interest rates as they prioritize restoring price stability through tighter financial conditions. Figure 4 illustrates how the historically negative correlation between stocks and bonds has become less reliable in a world of high inflation. Over the last two years, bonds have delivered negative returns on average on days when equity returns were also negative.

A systematic approach to market-neutral investing

We discussed the potential of market-neutral strategies to expand the investment opportunity set, take advantage of new return sources, and provide an added layer of diversification in portfolios. However, not all market-neutral strategies are created equal. In our view, a systematic approach helps to maximize the effectiveness of market-neutral investing.

Systematic processes enable the granular, data-driven analysis to be scaled across the entire breadth of the market every day. Stocks are then scored and ranked daily, combining into a view of the extent that each security is expected to outperform or underperform on a relative basis. The breadth and speed of analysis allow systematic investors to quickly identify alpha opportunities as they arise across the market. Beyond security selection, systematic processes support the rapid recalibration of portfolios that’s necessary to remain nimble in a more volatile regime.

Finally, investment insights are implemented through a process that explicitly balances return considerations with risk and cost tradeoffs. This helps to limit unintended bets or concentration risks that can surface if not closely monitored. The ability to scale investment insights, capture alpha opportunities, and manage risk exposures makes a systematic process well-suited for market-neutral investing.

Conclusion

The benefits of market-neutral investing have become increasingly relevant amid heightened uncertainty and volatility. As investors look to evolve the traditional 60/40 portfolio to address today’s challenges, market-neutral strategies may help target differentiated return sources like security dispersion to complement existing allocations with an additional source of diversification and return. Taking a systematic approach can help to maximize the effectiveness of market-neutral investing—providing the breadth, granularity, and speed that’s needed to capture opportunities in the new regime.

¹ The 60/40 portfolio refers to a portfolio where 60% is invested in stocks and 40% is invested in bonds, which is the initial starting point for many investor portfolios.

² “Going long” refers to investing in securities that are expected to outperform. Short selling or “going short” is a strategy for generating returns when a stock’s price is falling. When an investor goes short a stock, the investor borrows the stock from a lender and sells the stock at the current market price. Next, the investor buys the stock back at a lower market price sometime in the future so that they can return the stock to the lender. The difference between the investor's initial sell price and the buy price is the profit. For example, if an investor thinks XYZ stock is overvalued at $100 per share, and is going to drop in price, the investor may borrow 100 shares of XYZ from a lender, and then immediately sell it for the current market price of $100. If the stock goes down to $90, the investor could buy the 100 shares back at this price, return the shares to the lender, and net a profit of $1,000 ($10,000 - $9,000). However, if XYZ's stock price rises to $110, the investor would lose $1,000 ($10,000 - $11,000).

³ Alpha refers to the excess returns earned on an investment.

Investing involves risks, including possible loss of principal.

Key risks of the fund: This fund is actively managed, and its characteristics will vary. Stock values fluctuate in price so the value of your investment can go down depending on market conditions. International investing involves special risks including, but not limited to currency fluctuations, liquidity, and volatility. These risks may be heightened for investments in emerging markets. The issuers of unsponsored depositary receipts are not obligated to disclose information that is, In the United States, considered material. Investing in long/short strategies presents the opportunity for significant losses, including the loss of your total investment. Such strategies have the potential for heightened volatility, and in general, are not suitable for all investors. The fund may use derivatives to hedge its investments or to seek to enhance returns. Derivatives entail risks relating to liquidity, leverage, and credit that may reduce returns and increase volatility. The fund may engage in active and frequent trading, resulting in short-term capital gains or losses that could increase an investor's tax liability. Short-selling entails special risks. If the fund makes short sales in securities that increase in value, the fund will lose value. Any loss on short positions may or may not be offset by investing short-sale proceeds in other investments. Investing in small- and mid-cap companies may entail greater risk than large-cap companies, due to shorter operating histories, less seasoned management, or lower trading volumes. Fixed income risks include interest rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Asset allocation strategies do not assure a profit and do not protect against loss.

This information should not be relied upon as research, investment advice, or a recommendation regarding any products, strategies, or any security in particular. This material is strictly for illustrative, educational, or informational purposes and is subject to change. This material represents an assessment of the market environment as of the date indicated; is subject to change; and is not intended to be a forecast of future events or a guarantee of future results. Reliance upon information in this material is at the sole discretion of the viewer.

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Stock and bond values fluctuate in price so the value of your investment can go down depending on market conditions. International investing involves special risks including, but not limited to political risks, currency fluctuations, illiquidity, and volatility. These risks may be heightened for investments in emerging markets. Fixed income risks include interest rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Asset allocation strategies do not assure a profit and do not protect against loss.

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