Market neutral funds invest in equity or debt, but attempt to hedge out most or all equity market risk, instead earning returns by taking on other risks, such as idiosyncratic company risk, illiquidity risk, and selling insurance. Market neutral funds typically exhibit betas to broad stock market indexes of between -0.3 and 0.3, and returns can be measured against a cashlike benchmark, such as U.S. Treasury bills or LIBOR.
Equity market neutral funds focus on idiosyncratic company risk, taking long bets on stocks expected to appreciate in price, and shorting an equivalent amount of stocks that should decline in value. The beta, or collective market risk, of the long stocks should virtually offset that of the short stocks, such that when the stock market goes up or down, these funds will not be affected. A good, unlevered equity market neutral fund can be expected to produce (annualized) returns of a few percentage points greater than cash.
Merger arbitrage funds take long positions in target stocks of announced acquisitions, and short the acquirer's stock (in a stock-for-stock deal), so as to isolate and capture the premium paid for the target's stock. The premium compensates arbitrageurs for taking on the risk that the deal may not close. In an all-cash deal, arbitrageurs may hedge out equity market risk by writing calls or buying puts on the target stock. Merger arbitrage profits are driven by deal flow activity, the premiums paid for targets, and the number of arbitrageurs in a particular deal.
Convertible arbitrage funds take long positions in convertible bonds, which have an embedded equity option. The equity market risk is neutralized by shorting the stock of the same issuer. Convertible arbitrageurs attempt to profit from mispricing in the underlying bond or changes in the value of the equity option. Because convertible bonds are a relatively illiquid asset class, holders of convertible bonds are compensated for this illiquidity. Convertible bond issuance and the number of arbitrageurs also affect returns in this strategy.
Other arbitrage strategies strive to profit from the relative pricing of two similar securities. For example, capital structure arbitrage may take long positions in underpriced and short positions in overpriced securities of the same issuer, such as different share classes of the same equity. It is prudent to diversify arbitrage strategies, because they go through different boom and bust cycles.