A traditional share investment, sometimes referred to as a ‘long only’ share investment, is where an investment manager creates a portfolio of shares he believes will outperform the market. The problem is, even though the investment manager may have an exceptional share selection method that consistently beats the market, if the overall market falls by 50%, then the portfolio may still fall by 40% or more, and a 40% loss of capital is always bad, no matter what the context.
A market neutral manager does not try to outperform the market. Instead, he tries to remove as much share market risk as possible. To achieve this, rather than just create one portfolio, a market neutral manager creates two portfolios – a long portfolio containing highly ranked shares (those shares the manager believes have the best prospects), which profits from rising prices, as well as a short portfolio of lowly ranked shares (those shares the manager believes have the worst prospects), which profits from falling prices. Each portfolio is of approximately equal dollar value. With a long and a short portfolio of equal dollar value, a profit will result, provided that the long portfolio rises more or falls less than the short portfolio, regardless of whether the market goes up, down, or completely sideways. Of course, if the short portfolio outperforms the long portfolio, a loss will occur. The key point is that the returns are largely independent of market direction, as the market neutral manager believes he has a much higher probability of selecting shares than predicting the direction of the overall share market, and by being market neutral, he can implement his share selection method without the constant worry of a share market correction or collapse.