Investing your money without exposure to systemic market risk sounds like the utopian dream of a rookie investor. However, there are investment strategies geared towards satisfactory market performance, whether prices drop or rise.
Due to their low positive correlation with overall market performance, they’re called “Market Neutral.”
What Does Market-Neutral (Actually) Mean?
The Market Neutral approach is an investment strategy designed to secure profits in all market conditions. A portfolio is market neutral when long and short positions have nearly no correlation with even drastic market fluctuations.
To achieve market neutrality, the portfolio's overall volatility (beta) should be as close as possible to 0.
The guiding principle is to ride the momentum wave. To accomplish this, investors look for securities (qualitative approach) or pairs (statistical correlation) with a potential arbitrage opportunity, taking simultaneously long and short positions.
What does that mean?
Convergence occurs when the price of a future at the time of the fulfillment of its contract and the price of the underlying commodity are equal. If this does not occur, there's an opportunity for an arbitrage (profit).
There can be two types of arbitrage:
Fundamental arbitrage occurs when using fundamental analysis to predict securities' long-term profitability.
Statistical arbitrage implies using quantitative algorithms to uncover undervalued ones. Gains occur when both the long and short positions are profitable. Still, alternating opposing positions should ensure a balanced system.
Is it more convenient than traditional (directional) trading?
Directional Trading vs. Market-Neutral Strategy
Let's think about a match for the World Heavyweight Championship title. The reigning world champion takes the challenge, betting on his athletic preparation and winning attitude. He's the champion. The odds are on his side.
Boxing fans may do the same. Or, bet against him. Maybe because the opponent is hungrier to win than the current champion.
That's an example of directional trading: you have two options and bet in favor of an event (long position) or against it (short position).
Guessing the final result can guarantee a considerable return (especially if the event is deemed unlikely). Still, this type of bet conceals a significant risk: losing the capital invested if the outcome is the opposite of the chance.
(Certain) high risk = (potential) high gain.
The idea behind a market-neutral strategy is straightforward: distribute the bets on one or more assets, so the winnings balance the losses.
This wouldn’t be possible in a sports event, but the market is a much more complex system of factors that allows its discrepancies to be exploited (as in the qualitative approach).
Thus, a market-neutral strategy aims to nullify the risks related to the possibility of one of the two events not occurring. Still, for the same reasons, as described before, other risks may compromise this balance.
How Does a Market-Neutral Portfolio Work?
Although conceptually intuitive, a market-neutral strategy is complex to set up. Arbitrage opportunities rarely happen, and there's no guarantee they will beat the market. Therefore, an investor may opt for those mutual or hedge funds whose managers adopt this strategy.
These fund managers add a (usually 10% to 20%) market-neutral component to the classic 60/40 mix of stocks and bonds.
Historical analyses have shown this component is sufficient to make the portfolio more stable without compromising its long-term performance.
Benefits and limitations of Market-Neutral Strategies
Being immune to market risk is difficult to apply in a broader sense, so a portfolio is considered market-neutral if it doesn't have correlations with a set of risks in a given asset class environment.
The problem is any unforeseen risk can alter the balance of the initial asset allocation.
The previous example on the sports event — in which only two outcomes are possible, making a balanced bet unprofitable — needs to do more justice to the market’s complexity. So, consider this:
Imagine two players competing for the same market niche, of which they have almost total dominance.
If one of them successfully pursues an initiative, it gains market share at the second one's expense.
Thus, going long on the first and short on the second (as in the statistical correlation approach) offsets the risks of directional trading.
But the risk a market-neutral strategy can realistically prevent is that of a closed system.
In this example, an unforeseen risk could be a new player's appearance, essential raw material scarcity, the loss of consumer interest in that product, or spending power reduction.
The possibility of an unforeseen event occurring can turn a market-neutral trade into a high-risk strategy comparable to directional trading.
- Additionally, a Market-Neutral fund can lead to operational problems. The Uptick Rule, put in place by the Securities and Exchange Commission (SEC) in 2010, requires any short sale to take place at a price higher than the last trading price of the security if the security has fallen by 10% or more from the closing price on the previous trading day. So selling short in a prolonged bear market period can be problematic.
- The need to operate consistently also entails higher costs related to the taxability of the transactions.
- A Market-Neutral strategy allows limited short-term returns because of its balancing market rallies. Therefore, those who opt for this strategy are interested in long-term investments.
There are no risk-free strategies, and market-neutral is no exception. However, this has considerable advantages, in addition to reducing a portfolio's exposure to market conditions:
- Allocating part of the funds in a Market-Neutral portfolio can be recommended for investors who enter the market in times of high uncertainty and volatility and are unwilling to navigate the turbulence.
- Asset diversification can help to reduce overall systemic and unforeseen risks. Thus, long-short positions on stocks can be complemented by similar positions on (crypto)currencies, gold, bonds, and commodities.
- A balanced system can allow one to invest a more significant amount of money that might be compromised in a directional trade.
Can Peccala be Considered as Market-Neutral?
Not entirely, but it has commonalities.
Peccala automated investing is not without risk. Peccala Tokens holders can opt for two different strategies, depending on their risk appetite:
- High-risk strategy: invest in crypto futures with up to 2x leverage.
- Medium-risk strategy: invest in crypto futures with a leverage of 1x.
However, in both cases, Peccala trades derivatives to benefit from up and down markets equally.
Peccala's trading engine works symmetrically (an asset that loses its value by half would be equally profitable as one that doubles its value), thus having a low positive correlation with the overall crypto market trend.
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