How To Design A Market Neutral Portfolio

Jan. 06, 2015 2:44 PM ETDIA, FXH, IWM, IWV, QQQ, SPY7 Comments

Summary

  • For whom is Market Neutral investing.
  • Making the short side safe.
  • Two simple examples.
  • Questions to solve for a real portfolio.

An investment is market-neutral if it seeks to avoid exposure to market risk, typically by hedging. It can use various techniques, like statistical arbitrage in pairs trading, options in delta hedging, stock picking in long/short portfolios. This article is the first one of a series dealing with implementations of the latter category.

Market Neutral Investor profile

Market neutral strategies are suitable for investors who think that the market is approaching a correction or a crash, and more generally for those who want to invest without caring if the market is approaching a correction or a crash. It is especially pertinent for investors who don't trust market timing, or who want a part of their investments to be independent of timing indicators. It is also pertinent for investors who are aware that several asset classes might sink together in specific deflationary environments, making inefficient the usual models of diversification in stocks, bonds, and hard assets. More generally, market neutral strategies attract risk-averse investors looking for capital protection, smoother drawdowns and a lower volatility.

At the opposite, bullish investors used to long-only investing may be frustrated by an equity market neutral portfolio, which often underperforms the benchmark in a rising market, and whose equity curve may sometimes go down for a while whereas indices are going up.

Making the short side safer

An equity market-neutral portfolio generally holds equal amounts in a group of long positions and a group of short positions within a stock universe. The universe can be global (the whole stock market), focused on a country and market capitalization segment (for example the S&P 500 index), or specialized in a sector or industry (for example healthcare, biotechnology,…).

I am personally reluctant to sell short individual stocks, and I know that I am not alone here. If you don't understand why some

This article was written by

Fred Piard profile picture
14.71K Followers
Data-driven portfolios and risk indicators.
Author of Quantitative Risk & Value and three books, I have been investing in systematic strategies since 2010. I have a PhD in computer science, an MSc in software engineering, an MSc in civil engineering and 30 years of professional experience in various sectors. My aim is making simple and efficient quantitative investing techniques available to my followers. Quantitative models can make investment decisions faster, reproducible and emotionless by focusing on relevant information in the middle of market noise. Moreover, models can be refined to meet specific risk tolerance and objectives. 

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I am an individual investor and an IT professional, not a finance professional. My writings are data analysis and opinions, not investment advice. They may contain inaccurate information, despite all the effort I put in them. Readers are responsible for all consequences of using information included in my work, and are encouraged to do their own research from various sources.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Past performance, real or simulated, is not a guarantee for the future.

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