And a short primer on the strategy.
Months of near-consistent outflows have taken a toll on the market-neutral Morningstar Category: Total assets for these funds have dropped from a peak of $34 billion in August 2014 to $21 billion at the end of May 2017.
However, two of the top five largest funds in the market-neutral category—Vanguard Market Neutral VMNIX and AQR Equity Market Neutral I QMNIX—have grown their total assets substantially during this period. Below, we provide an overview of equity market-neutral investing and the associated capacity concerns with the strategy and these funds.
Equity Market-Neutral Strategies’ Distinguishing Features
Systematic market-neutral equity long/short strategies typically deploy capital both in developed and leading emerging markets. They’re also usually based on fundamentally and technically driven substrategies, with dollar and beta neutrality generally maintained at the fund/strategy level.
The funds use leverage to varying degrees to amplify their returns, which are driven primarily by pure alpha (for example, company-specific diversifiable risk) or style factors (such as value, momentum, quality factors, and so on). In its purest form, a market-neutral fund should not only target maximum factor diversification, but also factor neutrality. In other words, a single factor should not drive, say, only the long side of the portfolio without management also shorting the weak stocks in that specific factor.
These funds primarily invest in plain-vanilla equity securities, but they also trade synthetic instruments like equity swaps or "contracts-for-difference," where it is difficult to borrow stocks for shorting purposes (particularly in emerging markets). Instead of looking for the home-run picks that drive returns for many fundamental stock-pickers, market-neutral managers look for relatively smaller anomalies in the equity markets. These anomalies can exist due to investor preferences, indexation, demand and supply anomalies, and other factors. Since the expected returns for individual trades are relatively small, it is not uncommon for these funds to use leverage and hold several hundred stocks, if not thousands, in their portfolio (counting long and short positions), and have relatively high turnover.
This type of investing requires sophisticated technological and investment infrastructures. The investment processes often consist of risk-modeling and optimization protocols, stock-selection models, and transaction-cost modeling. These components generally work in tandem to ensure that the portfolios are properly diversified, and that dollar, beta, and factor neutralities are maintained as market conditions change (assuming the manager targets such neutrality). Automated trade-execution systems need to be integrated with middle-office risk-management systems to ensure smooth execution.
A large number of mostly fundamental and technical factors combined in different configurations comprise the building blocks of market-neutral investing from a bottom-up perspective. Managers combine the factors—style or otherwise—into separate substrategies that are clustered into themes such as valuation, profitability, quality, investor sentiment, and liquidity, and sometimes more-complex themes like catalyst-driven trades.
Identifying these factors and developing them into alpha-generating modules requires large sets of data collected from not only major data sources like Bloomberg and Morningstar but also using other means, including proprietary data sets. Managers have devoted much research to this latter area in order to further diversify the building blocks of quantitative investing, emphasizing newer techniques like machine learning in addition to traditional statistical techniques. Managers have experimented with artificial intelligence, neural networks, random forests, natural language processing, and other methods to enhance the alpha-generation process. However, it is too early to say if these conceptual methods can add consistent value in the real world.
Interest-rate levels also have an impact on returns for market-neutral strategies. These operationally intensive strategies need strong cash management systems to minimize errors because of trade settlements, manage the desired level of leverage, minimize the cost of shorting stocks, and maximize the yield earned on cash proceeds from shorting stock. The level of short-term interest rates directly affects the cash proceeds from shorting stocks, and near-zero short rates have acted as a headwind for market-neutral funds.
Quant Quake versus Flash Crash
During two notable stress periods, markets moved adversely for quantitative equity market-neutral and statistical arbitrage funds (both are subsets of market neutral strategies): the quant quake of August 2007 (which started on Aug. 1, around 10:45 a.m.) and the flash crash of May 2010 (May 6 at 2:45 p.m.). In August 2007, quantitative equity strategies experienced a deleveraging event leading to liquidations in the hedge fund space, an event possibly caused by discontinuation of credit lines from the leverage providers (for example, prime brokerage counterparties). The adverse moves on both long and short sides of the portfolios were not a product of a general market sell-off but rather deleveraging by quantitative funds that used similar "factor" exposures to pick stocks.
This portfolio deleveraging led to significant losses by quantitative equity strategies. Some quantitative market-neutral hedge funds that deployed 8 to 10 times portfolio leverage lost approximately 20% on average. Equity market-neutral strategies within the mutual fund space typically do not use as much leverage as hedge funds, which should prevent losses of similar magnitude.
The flash crash of 2010, meanwhile, was more of a statistical arbitrage phenomenon. Pure statistical arbitrage funds "provide liquidity" in the markets on the basis of short-term technical signals, identifying price deviations from predefined ranges. For example, a statistical arbitrage fund can seek to enter a falling market, providing liquidity on the long side in an effort to take advantage of an ensuing rally in that stock. These strategies have a trading orientation that is much higher in trading frequency and fundamentally different from traditional quantitative market-neutral equity strategies; the latter generally deleverage given a disorderly price action, realize lower portfolio turnover, and seek to profit on longer-term factor-driven alpha opportunities. Many statistical arbitrage funds that provided liquidity halted trading during the flash crash, likely contributing to the drying up of liquidity during the event.
Alpha Is a Scarce Commodity
Absent these relatively isolated market-moving events, the list of sources of alpha that managers can access is theoretically long and can include demand and supply imbalances, investor class preferences, regulatory changes, noneconomic buying and selling obligations, demand for and provision of liquidity, imbalance between speculators and hedgers, portfolio rebalancing, index rebalancing, investor sentiment, and market exuberance on quantitative methods. However, these sources of alpha are often transitionary and do not allow for unlimited amounts of capital, so investors should be cognizant of fund asset sizes.
We’re keeping an eye on two funds in particular: Vanguard Market Neutral and AQR Equity Market Neutral, which have been extraordinarily successful in raising capital. Just two years ago, Vanguard Market Neutral stood at roughly $400 million in assets, and strong inflows have pushed assets to almost $2.1 billion through May 2017. AQR Market Neutral had just $26 million in May 2015, and this fund has grown more than 50-fold, to $1.4 billion (in fact, it will close to new investors as of June 30, 2017).
Because these funds attempt to take advantage of return sources other than traditional market beta, their ability to generate attractive returns at their current sizes should be monitored. For example, market-neutral funds often short mid- to small-cap stocks that have limited liquidity at a higher cost, so the larger the fund, the harder it is take advantage of those opportunities. In addition, the amount of leverage used may increase with the fund's size because the incremental return that management aims to capture in a substrategy gets thinner with larger trades.
Equity market-neutral investing has been a popular strategy in the alternatives industry and can provide good diversification benefits, downside protection, and a unique source of return. But investors in this space—and in these two funds in particular—should be aware of capacity concerns when it comes to earning uncorrelated alpha-driven returns in the liquid alternative space.