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AIMA Canada Strategy Paper Series: Equity Market-Neutral Strategy
When effectively managed, an equity market-neutral strategy should generate returns in excess of cash, while being largely independent of the market’s performance…
What is Equity Market-Neutral?
Equity market-neutral hedge funds buy stocks (go long) and sell stocks (go short) with the goal of neutralizing exposure to the general stock market and capturing a positive return, regardless of the market’s direction. Equity market-neutral is a term that includes different equity strategies with varying degrees of volatility, and an emphasis on maintaining neutrality to the equity markets. When effectively managed, an equity market-neutral strategy should generate returns in excess of cash (i.e., T-bills or LIBOR), while being largely independent of the market’s performance. Thus, the returns captured from the stock selection process should be the value added by the manager.
An equity market-neutral strategy seeks to generate returns by exploiting equity market inefficiencies, and involves simultaneously holding long and short equity portfolios of approximately the same dollar amount. Trades involve buying attractive stocks, the long portion of the portfolio, and selling unattractive stocks, the short portion of the portfolio. The spread between the performance of the longs and the shorts, and the interest earned from the short rebate, provides the primary return for this strategy. Equity market-neutral may be viewed as a natural extension of long-only equity management, as it typically focuses on the fundamental factors associated with stock picking.
The variety of global equity markets and sectors creates many possible permutations and combinations of universes for equity market-neutral managers to explore. Also, since data for equities in developed markets are readily available, managers can use advanced mathematical algorithms and rigorously back-test models.