Equity Market Neutral Strategy

Like many other hedge fund strategies, equity market neutral (EMN) managers establish long and short positions in undervalued and overvalued securities.  Unlike long/short managers, EMN positions are balanced along  sector, currency and country lines.  For example, the manager may go long Intel by buying $1 million and go short by selling $1 million of Advanced Micro Devices.  Since both companies are in the same sector, the fund has a neutral position.  This is a simple example.  The manager may choose to create a neutral position by using derivative securities.  For example, a long position in British stocks would be hedged by a futures position in the British Pound.  Any fluctuation in the US Dollar to British Pound exchange rate would not affect the portfolio.  The goal is to have no net exposure to market, industry or foreign exchange risk.  The only source of return is picking the right securities.  This is called the rule of one alpha (Bruce Jacobs and Kenneth Levy, "The Law of One Alpha", The Journal of Portfolio Management, Summer 1995).

To create these portfolios, the manager usually follows these steps:

1. Establish a universe of stocks
2. Generate a forecast
3. Build the portfolio

For more details on these steps, consult with this AIMA Canada paper or Mark Anson's Handbook of Alternative Assets.

Since the portfolio is constantly being hedged due to changing market conditions, it is important to own securities that are liquid.  A position in a stock that is thinly traded will not give the manager the flexibility to dynamically hedge against market events.