Thomas Linkas and William Elcock of Batterymarch discuss the increasing role of these long-short strategies in portfolios

Over the past decade, investment managers have sought to add value in the US equity market through innovative investment strategies such as market neutral portfolios. These strategies are designed to provide a consistent source of alpha, with a moderate level of risk and low correlation to other equity investments.

Until recently, market neutral investing has been confined primarily to the US market because of restrictions on short selling in other parts of the world. These constraints no longer apply, however, in nearly 20 other countries including Japan, Germany and Hong Kong. This should encourage the proliferation of market neutral mandates beyond the US.

How Market Neutral Equity Investing Works Market neutral strategies are designed to minimise the effect of overall market risk on portfolio performance through specific portfolio construction techniques. A market neutral manager includes long and short stocks together in a single portfolio, which is market cap band neutral, sector neutral and in equal dollar balance at all times. This portfolio structure effectively neutralises market exposure so that returns are not affected by the direction of the overall market.

As a long-short strategy, market neutral investing has an added benefit: the use of both long and short positions doubles the number of investment opportunities versus traditional long-only portfolios. This combination of longs and shorts enables managers to gain alpha on both the long and short sides of the portfolio.

The goal for most market neutral managers is to provide consistent absolute risk-adjusted returns. In addition to that, investors receive an interest rebate on the short-sale proceeds - usually a rate similar to 90-day US Treasury bills.

Integrated Long/Short Portfolios There are critical benefits to managing market neutral assets using an integrated long/short strategy rather than dividing the assets in separate long and short portfolios. Most importantly, separate long and short portfolios would have a riskier profile. As an example, a long-only manager might be long oil stocks while the corresponding short-only manager is short airline stocks. If oil prices drop, oil stocks will fall and airline stocks will rise - causing the portfolio to lose value on both the long and short sides. In another example, one manager might buy a stock long, while the other manager - who might use a different investment style or different valuation methods - might sell the same stock short, which would negate a coordinated long-short strategy.

A market neutral portfolio manager with responsibility for both longs and shorts in a single portfolio takes into account how the long and short positions interrelate - in terms of asset amounts, sectors, market cap exposures and other variables - so that the long and short sides of the portfolio can truly offset each other. In addition, coordinated long-short strategies such as market neutral effectively put investment assets to double use, because the assets invested on the long side also collateralise the short side.

Inherent Risks The greatest risk in using a market neutral strategy lies in the investment manager's stock selection capabilities - because a manager can lose money on both the long and short sides of a portfolio due to unfavorable stock selection.

Theoretically, there is no limit on how much a manager can lose on a short position - because there is no ceiling on how high a shorted stock can climb. In actual practice, however, shorts are covered as their prices rise above a certain threshold, which serves to dampen any short-side losses. For well-diversified portfolios, no single position - either short or long - will have a significant effect on overall performance.

Market neutral strategies can create additional issues. One of the challenges can be finding enough stocks to short, since not all stocks are easily borrowed - usually because many investors have already shorted them or they are simply not available.

Occasionally, even a stock that is not difficult to borrow can create a challenge for short sellers. This can happen in what is known as a 'short squeeze', where some investors purposely reduce the availability of a stock while they increase its price through purchases. In that case, a manager may have no choice but to cover the stock at an artificially high price.

This is not a great concern for many market neutral managers, however, because they tend to hold numerous positions in their portfolios, which dilutes the effect a short squeeze can have on overall performance. At the same time, market neutral managers often focus on more liquid stocks, where it is more difficult to manipulate stock lending and share prices.

The Quantitative Advantage Although most quantitative models were originally developed to identify attractive stocks for long portfolios, by their nature they also identify unattractive issues - stocks that are likely candidates for shorting. Because of this, many quantitative managers are now seeking to leverage both tails of their models by introducing market neutral strategies.

Market neutral managers who use quantitative methods hold key advantages over those using traditional fundamental techniques. For instance, fundamental managers are restricted to the relatively small universe that individual analysts can personally cover. This abbreviated universe translates into portfolios with fewer holdings - adding the element of risk that comes with less diversification. Some fundamental approaches also may depend heavily on the opinions of an individual analyst, who may inadvertently bias the portfolio in a particular direction.

Quantitative managers, on the other hand, use techniques that are specifically designed to evaluate and rank stocks dispassionately. Computer models are especially well suited to market neutral stock selection. They can handle enormous amounts of data, for example, so there is no need to exclude any stocks for lack of analytical resources. The larger investment universe engendered by quantitative techniques also makes it easier to avoid hard-to-borrow stocks, which reduces the likelihood that investors will be forced to cover a position if a lender demands to have a security back.

It is important to note that using a quantitative approach does not mean having to abandon all the positive aspects of fundamental analysis. The most effective quantitative models encompass the same broad dimensions followed by fundamental investors: cash flow, earnings growth, expectations, value, technicals and corporate signals.

The use of optimisers in constructing market neutral portfolios - rather than building them manually - is also particularly effective. Because optimisers consider all the variables simultaneously, they are extremely efficient tools for balancing longs and shorts in terms of market cap, sectors, asset amounts and other considerations.

Future Applications Market neutral strategies are no longer limited to the US or even just to stocks. There is now interest in market neutral portfolios in non-US equity markets where restrictions on short selling have recently been lifted. Although it is much less common, some investment managers also apply market neutral strategies to fixed income securities as well as other asset classes. As time goes by, market neutral mandates are likely to play a greater role in the asset allocation mix. Many institutional investors are becoming more interested in hiring managers who can consistently produce 'pure alpha' - absolute return that is unrelated to a particular asset class. Market neutral strategies can be used not only to achieve this objective, but also to help investors meet their asset allocation goals.

This can be accomplished by using market neutral portfolios for purposes other than cash enhancement, where US Treasury bills are typically the benchmark. Instead, investors can gain exposure to virtually any other asset class by investing some of the proceeds of the short sales in futures. This concept is sometimes described as 'portable alpha,' which essentially means that investors can combine a manager's alpha with the returns from any underlying asset class.

Investors may one day implement their overall asset allocation decisions by first finding managers who do the best job at delivering alpha - and then simply combining the alpha from each one with the appropriate market exposure.

Market neutral strategies can clearly be very helpful to institutional investors - whether they use them to avoid market volatility and enhance cash returns or choose to transport alpha as part of an asset allocation plan.

Thomas Linkas, director of developed markets, and William Elcock, US portfolio manager, manage market neutral assets at Batterymarch Financial Management

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