The year 2012 finds the search still on for income and capital appreciation with acceptably low volatility. Many investors remain leery of stocks and are also interested in opportunities that possess low correlation to equity markets. In addition, the low interest rate environment presents difficulties for those trying to achieve total return goals by relying on fixed income investments. Given these issues, some may wish to learn more about the techniques utilized by many equity market-neutral (EMN) strategies.

Avoiding Equity Market Exposure

EMN strategies generally seek to take on both long and short positions in equities so as to minimize exposure to the systemic risk of the stock market. The philosophy driving this type of strategy is, ideally, to achieve a beta equal to zero, so that the delivered performance is derived strictly from pure alpha. That is to say, the goal of equity market-neutral strategies is to generate performance that is uncorrelated to stock market movements and is the result of active management’s ability to generate excess risk-adjusted return.

A simple explanation of EMN is to suppose an investor takes a long position in a stock (A, let’s say) he expects to appreciate in value. Now suppose the same investor takes a short position in a stock (B) he expects to depreciate in value and belongs to the same industry or subsector as A. Remember, going long means to purchase a stock and capture the gains if it appreciates in value. Going short means to borrow a stock that is expected to depreciate in value, sell it before that happens, and then buy it back after the fall in value (so that it can be delivered back to the stock lender). When successful, the investor going short has followed the buy low, sell high principle of profitability, only in reverse order! He has also made a profit from the difference of the high sell price and the low buy price.

In the scenario above, regardless of whether the market A and B belong to appreciates or depreciates, the market risk is minimized by the long and short trades and the surviving risk is security-specific. Under this scenario,¹ the payoff comes from the difference (or “spread”) between the return on the long position and the return on the short position. For example, suppose the market depreciates and stock A (long position) falls in price by $1 per share and stock B (short position) falls in price by $3 per share. Both stocks take a hit. However, it is possible for the losses from A to be more than compensated for by the gains from selling B at the original price and then buying it back at $3 less per share. Realize that the proper stock pick (A) and the proper stock hedge (B), that is to say, the proper matched pair, is essential to the success of this strategy.

Finding the Right Pair Types

Asset managers may invest an entire portfolio in the long/short matched pair manner discussed above. When enough matched pairs are picked correctly so that spread returns are earned, the EMN portfolio pays off. Next, we will discuss specific long/short matched pair techniques that can be used to obtain market neutral performance in equity markets. Although other methods exist by which market neutral results can be obtained, this discussion focuses on three basic techniques that can be employed using only equities and equity exchange-traded funds (ETFs). The three techniques involve:

• Matching up similar companies within the same industry, or
• Matching up a company with the corresponding ETF, or
• Engaging in share class arbitrage.

The first basic technique involves a portfolio manager or other investor applying what they know about the investable industry of equities under consideration. Undertaking the proper screening and research to identify a company to take a long position in is very important and is typically carried out first. Next, a company in the same industry but with opposite prospects (to be shorted) needs to be identified. Typically, portfolio managers attempt a better pairing by matching up the levels of capitalization between the long and short position stocks as well.

A practical way to think of the matchup is that the two stocks need to be close substitutes for one another. As much as is practical, pair types should be close substitutes according to multiple methods of classification but differing in expected performance. The long position stock should be one that is expected to appreciate in value based on its own merits and internal attributes. The short position stock should be one that is very similar to the first but is expected to depreciate in value. Two key points should be kept in mind with trading tightly matched pairs of stock in this manner; first, the two-sided trade helps to minimize equity market risk; and second, the market’s inability to operate perfectly at all times affords talented managers the opportunity to make profitable investments.

The second basic technique is somewhat of an extension of the first. Sometimes good opportunities present themselves for long position investment but no desirable corresponding short position equity is available. In that case, the next best alternative may present itself in the form of an industry exchange-traded fund (ETF). ETFs are available for a wide variety of sectors and industries. By matching up a long equity position against a short position in the corresponding ETF, the portfolio manager is again mitigating market risk and again capturing spread returns by applying their marketplace knowledge and investment skill.

The third basic technique for executing a pair type EMN strategy is share class arbitrage. It is helpful to keep in mind that the general definition of arbitrage is to simultaneously purchase and sell an asset to benefit from a difference in the price due to different markets (e.g., geographic markets) or different asset forms (e.g., different share classes of the same stock). Share class arbitrage exists by virtue of companies that offer different share classes of their stock. Different share classes often arise out of the desire for shares that offer different levels of voting rights. Typically, the shares offering lower levels of voting rights are traded at a discount. This discounting, which the market performs imperfectly, results in differences in share class liquidity. Due to the discounting, spreads in dividend yield (if dividends are paid) can arise between the two share classes and investment opportunities come into being.

At times the spread between two share classes can become abnormally high. When taking a long position in a steeply discounted share class (with lower voting rights but a higher dividend yield), the expectation would be for this share class to appreciate so that the discount reverts back toward a historic mean. Correspondingly, the short position would be taken in the premium share class (possessing higher voting rights but a lower dividend yield) with the expectation this share class will depreciate in value so as to also contribute to the expected narrowing of the spread. To be successful, share class arbitrage aims to capture the excess spread between the two share classes as well as the dividend differential.

This piece serves as a limited introduction to equity market-neutral (EMN) strategies and pair type techniques that can be employed to achieve risk-adjusted return objectives. Investors seeking opportunities that provide low correlations to equity market movements may take an interest in learning more about EMN techniques and strategies. Those seeking alternatives to money market funds or other fixed-income investments may also find researching these techniques to be of value.

American Century Investments^® offers a wide variety of stock, bond and asset allocation funds. Visit americancentury.com for more information: Individual Investors | U.S Investment Professionals

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¹This scenario refers to a low interest rate environment where any proceeds from short sales held in cash as collateral and earning the Treasury Bill rate of return, are negligible.

The opinions expressed are those of Matt Oldroyd, CFA, Vice President, Client Portfolio Manager, and are no guarantee of the future performance of any American Century Investments portfolio.

This information is not intended to serve as investment advice; it is for educational purposes only.

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