Market Neutral: Definition, Strategy, Risk, and Benefits

Ali Hussain has a background in finance with large financial institutions and in journalism covering business.

What Is Market Neutral?

A market-neutral strategy is undertaken by investors or investment managers to profit from both increasing and decreasing prices in one or more markets while avoiding specific market risk.

Market-neutral strategies involve taking long and short positions in different stocks to increase returns from good stock selections and decrease returns from broad market movements.

Key Takeaways

• Market neutral is an investment strategy employed by managers to profit from price fluctuations in financial markets.
• This strategy serves as a hedge against significant losses by combining long and short positions.
• Hedge funds often employ market-neutral strategies with the objective of absolute returns.
• The two main types of market-neutral strategies are fundamental arbitrage and statistical arbitrage.
• Market-neutral strategies have low positive correlations to the market and focus on stock price convergence.

Understanding Market Neutral

There isn’t a single accepted method of employing a market-neutral strategy. Strategists may also use tools such as merger arbitrage and sector shorting.

Managers who hold a market-neutral position can exploit market momentum. Hedge funds often take this position to prioritize absolute returns.

Market-neutral strategies are often compared to long/short equity funds, but they have distinct differences. Long/short funds vary stock exposures across industries, while market-neutral strategies focus on pricing discrepancies and hedging out systematic risk.

Types of Market-Neutral Strategies

Fundamental arbitrage and statistical arbitrage are the two main types of market-neutral strategies. Fundamental investors use analysis to project a company’s path forward and make trades based on predicted stock price convergences.

Statistical arbitrage funds use algorithms and quantitative methods to uncover price discrepancies and trade on stocks likely to revert to their price means.

Market-neutral funds focus on constructing portfolios to mitigate market risk, making them likely to outperform other strategies during periods of high volatility. They have historically shown the lowest positive correlations to the market.

Example of a Market Neutral Fund

The Vanguard Market Neutral Investor Shares Fund (VMNFX) is a market-neutral strategy fund that utilizes long and short-selling strategies. Its objective is to minimize the stock market’s impact on returns, resulting in returns that may differ from the overall market.

The fund chooses short positions by evaluating companies in five categories: growth, quality, management decisions, sentiment, and valuation. It then shorts stocks with the lowest scores based on a composite expected return.

Investing in market-neutral funds is typically for high-net-worth individuals, with minimum investment amounts often exceeding $50,000. Some funds may also have high expense ratios compared to passively managed funds.