Market Neutral Investing in a New Regime
- 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.