I recently had a good friend ask me to explain how to construct a market neutral portfolio, since I currently do most of my personal investing in a market neutral style. If for any reason you've wondered about the logic, reasoning and method behind this popular hedge fund strategy- this post is for you, and I'll do my very best to write it without jargon at the risk of oversimplifying some concepts. If this seems like a dreadfully boring topic, I can hardly blame you and can only sheepishly admit that I'm a nerd and find this all fascinating enough to spend some of my free time running a similar strategy at an amateur level.

What is a market neutral portfolio?

The basic premise underlying a market neutral portfolio is that the ultimate performance of stocks can be broken down into various factors. A factor is a persistent explanatory variable that drives performance for more than one stock. Some examples include the performance of the overall stock market (beta), country exposures, size of company, etc. You can think of factors as the outputs of a huge multiple regression looking to explain stock returns over a given period using various well-known traits. One of the easiest factors to conceptualize is the price of oil for oil companies. If the question you are asking is "will XYZ oil stock go up in the next few years?" a major part of the answer is what happens to the price of oil, independent of the actions management takes. When you buy shares in the company, you are betting on both the company and oil prices. The price of oil is a factor. The more of any one individual company's performance it dictates, the larger of a "factor" it is. Statistics can break down each company's performance into various factors, eventually leaving a portion of returns that are down to the individual characteristics of the company.

It is important not to treat factors as gospel, especially when statistically derived. They are mathematical constructs first and foremost, they aren't set in stone, and the underlying correlations can vary significant day to day. That said, they are an important lens for an investor in public equities to understand what bets they are intrinsically making. If you buy a stock, you aren't just betting on just the company alone, but rather a basket of factors + the idiosyncratic risks/rewards associated with the company. If you are a US investor and happen to speak Norwegian and spend all of your time researching Norwegian stocks, no matter how much individual company research you do the driving factor behind how your portfolio performs will be how Norwegian stocks as a whole do.

How do factors relate to market neutral portfolios? Market neutral portfolios use various means to remove the beta factor from the equation. Beta relates to how the company moves with a benchmark. A company with a beta of 2 vs. the S&P 500 will generally go up or down about twice as much as the S&P 500 on any given day, all else equal. "Market neutral" means a portfolio that has been engineered to have a beta of 0. If you regressed a market neutral portfolio's daily returns against the S&P 500's daily returns, there should be no correlation. You can take any factor and create a "neutral portfolio" with respect to it: for instance some energy hedge funds run "oil neutral portfolios" where returns are designed to be uncorrelated to oil prices.

Market neutrality is useful because it provides returns that are not correlated to most other assets, and the "market factor" (beta) is often the largest one driving the performance of most portfolios. Instead, if well executed, market neutral portfolios generate returns based on the skill of the investors involved at picking good companies and making smart (non-beta) factor bets. A market neutral portfolio run with no "skill" at picking the right companies should generate no return whatsoever over time, a big cost compared to the ~5-10% returns that are normally earned investing in the stock market outright. If you don't plan on devoting enough time and effort to make a run at picking the right stocks, cash is a great option: market neutral, but with far less effort.

How to build a market neutral portfolio:

So say you're feeling smart (or lucky) and you want to build a neutral portfolio rather than hold cash: how do you start? It is theoretically possible to have a computer scan your portfolio for market exposure and places trades to counter it (many elite hedge funds employ a strategy like this), but that is out of reach for many individual investors and sometimes statistical noise can make the data less reliable than human intuition.

Instead, the best way for first timers is to start is with a pair trade: find a company you have a positive view on, buy it, and then short a company that has similar characteristics that you are negative on (it is also fine, though not preferable, to short a company on which you don't have a strong point of view either way). In a pair trade, you profit if the company you buy outperforms the company you short, even if both of them go down.

For example, say I was enamored with ServiceNow (NOW) as an investment because I thought its ITSM workflow platform would surprise the market with its ability to serve other enterprise use-cases like customer support and human resources. ServiceNow is a mid-cap horizontal SaaS company trading at a high EV/Gross Profit multiple, growing quickly and losing money. A natural pair trade is Workday (WDAY): it has all of the aforementioned characteristics, but I don't have a positive bias. If I have a negative bias (say because I believe that Oracle and SAP are firming up their cloud HCM and ERP product lines), all the better. If buy $1k of ServiceNow and short $1k of Workday, it is relatively safe to assume that the market will treat the two companies the same unless it learns new information about either of them- and so I have started an approximately market neutral strategy. Note: by picking another SaaS company, I am also achieving neutrality w.r.t. the multiples investors place on SaaS stocks. If SaaS companies multiples suddenly come down (as has happened most recently in the Spring of 2014 and February of 2016), both companies should fall and I may even make money if ServiceNow falls less.

A market neutral portfolio can be built as a set of pair trades, with each pair having companies with approximately similar traits/market exposure. In practice this is quite tedious. Instead, I manage a focused portfolio (10-15 longs and 15-20 shorts, with the shorts somewhat smaller and the values about equal long and short) and take care to make sure I don't have any exposure to the market by watching the betas of all of the companies. I also watch other factor exposures to make sure I'm not unintentionally better on "high growth SaaS" or against "old tech." Here are the daily returns of my portfolio (blue) vs. the Russell 2000 growth index (green). As hoped, there is little apparent correlation: sometimes I'm up when the index is flat, other times the index is up and I'm down.

Is a market neutral portfolio right for you?

This is hard to say, even if you think the market is in trouble. It is important to emphasize what you miss out on by being market neutral- investments in equities come with a reasonable expectation of a long run return, and you are forgoing that entirely by going market neutral by relying on your own wisdom (or the wisdom of a manager you hire). Over long time horizons, that can be a costly move: even if you bought right at the top in 2007 (say April 1st, 2007) you would have made a 5% return per year investing in the S&P 500 through today. That isn't a great return, but it is pretty impressive given the time frame.

Further there's reason for caution about your own ability (as an individual investor) to time the market. It is a tricky business, and even if you think that the market feels expensive/overbought today, that doesn't necessarily mean market neutrality is the right approach. An "overbought" market may mean that the market will crash, but a more reasonable way to think about it is that the market isn't likely to have particularly high returns over the next 5-10 years, for investors who buy in today. That may mean a crash and recovery, or it may mean five years of flatish returns- it is hard to say for sure.

For me, because I enjoy the game of picking stocks and am probably over-optimistic about my ability to do so, go-forward returns seem likely to be low enough that I'm willing to invest in a market neutral strategy and bet that I can outpace the market. If the rest of 2017 brings a meaningful decline in markets, I'd probably want to be less market neutral and more exposed to the long-term updraft that beta provides. This is a personal decision for each investor though, not a recommendation from me. That said, if you do decide to try to invest market neutral, hopefully this post gives you a basic understanding and a place to start.