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In theory market neutral funds are expected to run zero-beta portfolios, but do they really?

(Last Updated On: October 4, 2011)

In theory market neutral funds are expected to run zero-beta portfolios, but do they really?

Looking at the performance of equity market neutral hedge fund indices over the last few years, it doesn’t appear so. So is it that market neutral managers are running dollar neutral indices (instead of beta neutral) or is it a case of changing betas (due to risk-on, risk-off trades)..

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Different views on what market neutral means, very few traders I know use beta neutral constraint. Being dollar neutral (delta neutral) is not market neutral but I do know some traders who thinks so.

For me if you are trading equity long short then using country neutral, delta neutral, market cap neutral and sector neutral constraints and use equal weighting for each stock and roughly equal allocation for each country (if multi-country strategy) so that no single stock or country dominates the portfolio then that is sufficient and more than enough.

Can you actually make it beta neutral and delta neutral at the same time? .

 

 

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For one, we know that maintaining a delta-neutral portfolio perpetually is very costly (in terms of transaction costs) and would probably eat away any alpha you generate. Having said that I think it is possible to have a beta neutral portfolio with near delta-neutral exposure, but again it would require considerable effort in security selection (assuming you are running an equity portfolio and choose to stay away from derivatives) and be costly to maintain as well.

More importantly, if you were trying to create a market neutral portfolio while being delta neutral, you are eliminating all directional bias. So you are hoping to generate alpha through pure fundamentals led divergence. Such a strategy may be difficult to trade in markets where global macro trends trump fundamentals and where indices show increased correlations. In such markets, a small directional bias (by sacrificing delta neutral) can work very well…

Wouldn’t you agree?

 

 

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