DIY Investor Magazine
/
2015 Issue
36
NEUTRALISING THE MARKET….
SAFELY
Dr Fred Piard,
author of ‘The Lazy Fundamental Analyst’, introduces his market
neutral portfolio strategy
Market neutral investing uses sophisticated techniques
like statistical arbitrage, delta hedging and stock
picking to eliminate market risk. A possible advantage
is staying in the market and not trying to time the next
crash. Market neutral investing is supposed to offer
better capital protection and lower volatility but it is not
a perfect solution or for everyone. Aggressive investors
and market timers may be disappointed because it
often under performs the benchmark in bullish trends.
Here’s how it can work.
USING AN INDEX ON THE SHORT SIDE MAKES A
MARKET NEUTRAL STRATEGY SAFER
An equity market neutral portfolio usually holds
balanced amounts of long and short positions in a
stock universe. It can be a worldwide universe, a
national index (for example the S&P 500), a sector or an
industry (for example healthcare, biotechnology).
I am personally reluctant to sell short individual stocks.
If a market neutral approach is being used by a risk-
averse investor, it is better to avoid risks that are not
related to the market, like being trapped in a short
squeeze. This risk exists in all market segments, even
large companies. In 2008 Volkswagen AG became
briefly the highest capitalisation in the world.
Its share price was multiplied by five in two days. Short
sellers covered their positions with large losses, in
panic or forced by margin calls. Even absorbed in a
diversified portfolio, such a shock hurts. I prefer to sell
a benchmark index on the short side of a market neutral
portfolio, so as to avoid this kind of event.
US author Rick Ferri has published a white paper
comparing an all-index tracking portfolio with one
comprised of active mutual funds. He found the index
fund portfolio beat the active one 90% of the time, and
that this probability rose as time went on.
Despite this many investors still use several specialist
active managers to invest in each asset category. Such
diversity simply increases the chances of lagging the
market. Another approach is to outsource decision-
making to a multi-asset manager. But again their mix
of funds is likely to at best replicate the market, only
now there are two layers of fees to pay. justETF is an
online tool that supports the (superior) ETF approach. It
makes it easy for you to create and test your own ETF
portfolios that you can then replicate.
SECTOR DIVERSIFICATION MAKES THE
PORTFOLIO SAFER IN IRREGULAR MARKET
CYCLES
The long side of a market neutral portfolio aims to beat
the market in all (or most) phases of the expansion-
contraction cycle. Sector trends are linked to these
phases, at least in theory.
The reality is often more complicated. Cycles on
different time frames may be mixed and macro
factors can freeze some sectors (like the oil price did
for energy stocks in the second half of 2014). As a
consequence, it may be difficult to apply the cycle
theory and focus on the right sectors at the right time.
Sector diversification is a simple solution to keep draw
downs acceptable in depth and duration.
EXAMPLE: THE RUSSELL 2000 ‘LAZY’ PORTFOLIO
The following simulation is based on a portfolio mixing
all the Russell 2000 strategies of my book ‘The Lazy
Fundamental Analyst’. There are nine strategies, one
for each GICS sector except Telecommunication. Each
strategy selects 20 companies using two fundamental
factors. The result is an equal-weighted portfolio of 180
stocks. Of course, past performance, real or simulated,
is not a guarantee of future returns. But with so many
holdings, performance can hardly be suspected of
being curve-fitted or random.
