A large proportion of the risk from investing in the share market, and the one that causes investors the most sleepless nights, comes from broad market risk – i.e. when all shares fall at once, as in the recent Global Financial Crisis (GFC), or the 1987 stock market crash. Many investors are not aware that it is possible to largely remove this ‘market risk’ by adopting a market neutral investment strategy.

Why market neutral?

Traditionally, investors have sought their returns from cash, bonds, shares, and property, however, low interest rates have made cash and bond investments far less attractive, driving many investors to seek higher returns through more volatile investments, such as shares and property, which has increased the risk of their investment portfolios. Combining a low return investment (such as cash) with high risk investments (such as shares and property) does not necessarily produce a good, overall, risk-adjusted return. Further, the effect of falling share prices can eventually flow on to property prices, particularly if general economic conditions deteriorate.

As a result of holding a substantial portion of their investment portfolio in shares, or other investments, such as managed funds, that are closely correlated to the share market, many investors are currently over-exposed to share market risk. Effectively, this means that many investors are betting their financial future on just a handful of companies. For example, in June 2016, the top ten shares in the ASX-200 accounted for 42.73% of the index. Most investment portfolios suffer greatly when the share market crashes, or goes through long periods of negative performance. A recent example of this was the Global Financial Crisis (GFC), where the Australian share market (and other international share markets) fell over 50%, and several years later, the Australian share market is still well below its pre-GFC peak.

After suffering catastrophic losses during the GFC, many investors, in particular retirees, and those approaching retirement with substantial SMSF investments, questioned why they were so heavily exposed to share market risk in the first place, as history shows that whilst shares have fared well over the very long term, it comes at the expense of a great deal of volatility, and negative market conditions are reasonably frequent. Long term US data confirms that a bear market has occurred, on average, about every six or seven years, and the average fall has been approximately 40%. Obviously, such events can be devastating to the performance of portfolios heavily exposed to share market risk, as a 40% loss requires more than a 66% gain on the remaining capital to recover the loss.

Seeking the best investments

Many of the world’s leading investors, who continually search for the best investments, believe there are better ways to protect their wealth and at the same time, generate a reasonable return, and as such, they have developed a more broadly diversified approach to portfolio management, that is not dominated by share market risk. These investors have sought superior investment outcomes, by moving a substantial portion of their investment portfolios away from bonds and equities, and into the best alternative investments, including long/short equity hedge funds and market neutral hedge funds, in an effort to achieve better and more consistent returns with lower volatility through all economic conditions. An important area of alternative investments is market neutral investing, which has been prevalent for several decades and is now gaining in popularity, as investors become more knowledgeable about more sophisticated investment strategies.

How is a market neutral investment different from a normal share investment?

A traditional investment in shares relies heavily on the direction of the overall share market, and whilst individual share selection may contribute in some degree to overall performance, most of the returns and the risk in a reasonably diversified portfolio are derived from the overall direction of the share market. For example, during the GFC, even very well diversified portfolios of blue chip shares suffered substantial losses, providing little protection against the significant market decline. Therefore, most of the risk and return still depends upon the movement of the overall market.

In a market neutral investment, this logic is reversed, with virtually all of the returns and risk coming from the individual shares selected by the investment manager, and virtually no losses or gains resulting from the overall direction of the share market. The theory behind market neutral investing, is to remove a very large risk, i.e. share market risk, over which the investment manager has no control, and to substitute it for a set of risks that the investment manager can manage much more effectively, i.e. the risks involved in individual share selection. Let’s now look at an example of an Australian market neutral fund.

The Rushton Global Market Neutral Fund

The Rushton Global Market Neutral Fund (“the Fund”) is a highly diversified Australian market neutral fund. On a regular basis, the investment manager of the Fund, Rushton Financial Services Pty Ltd (“Rushton”) analyses a massive amount of information about thousands of the largest and most heavily traded listed securities from around the globe, and then ranks these listed securities from best to worst. The ranking methodology is grounded in over three decades of academic and industry research, and considers hundreds of individual factors about each particular listed security, with the highest ranked being the listed security that, according to the strategy, has the best prospects over the short to medium term, and the most lowly ranked being the listed security that has the worst prospects over the same period.

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Based on these rankings, Rushton then create an overall portfolio, which is divided into two distinct sub-portfolios, each containing hundreds of listed securities. There is the highly ranked sub-portfolio, containing those listed securities with the best prospects, and the lowly ranked sub-portfolio, containing those listed securities with the worst prospects.

Rushton then invests to ‘profit from rising share prices’ for the highly ranked sub-portfolio, known as ‘going long’ and to ‘profit from falling share prices’, i.e. ‘going short’ for the lowly ranked sub-portfolio. Approximately equal dollar amounts are invested for each sub-portfolio. The overall combined portfolio is a market neutral portfolio, as it has approximately equal positions in long and short Instruments, as per the following example.

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How a market neutral portfolio works

As approximately equal amounts are invested to profit from both rising and falling share prices, if every listed security (in both sub-portfolios) fell exactly 10%, what would be lost on the highly ranked (long) sub-portfolio, would be gained on the lowly ranked (short) sub-portfolio, which profits from falling share prices, so, in this example, there would be no profit or loss overall.

How is a profit generated?

To generate a profit overall, the highly ranked sub-portfolio must outperform the lowly ranked sub-portfolio. It doesn’t matter if the market falls, provided the highly ranked sub-portfolio falls less than the lowly ranked sub-portfolio, so outperformance need only be in a relative sense. And if the market rises, provided the highly ranked sub-portfolio rises more than the lowly ranked sub-portfolio, a profit is still generated. If the market moves sideways, it is also possible to generate a profit, provided that the highly ranked sub-portfolio outperforms, i.e. rises more or falls less, than the lowly ranked sub-portfolio. The bottom line, is that provided the highly ranked sub-portfolio outperforms the lowly ranked sub-portfolio, over time, the overall portfolio will continue to generate consistent profits – without the constant worry of the next share market crash. Consider the following examples.

EXAMPLE – RISING MARKET (Highly ranked sub-portfolio has outperformed the lowly ranked sub-portfolio)
This example assumes that the general direction of the share market is up, and that, in accordance with the rankings, the highly ranked portfolio has outperformed the lowly ranked portfolio. In this scenario, a 20% profit has been achieved on the highly ranked ‘long’ sub-portfolio, which profits from rising prices, but a 5% loss has occurred on the lowly ranked ‘short’ sub-portfolio, which profits from falling prices, producing a net profit of 15% overall.

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EXAMPLE – FALLING MARKET (Highly ranked sub-portfolio has outperformed the lowly ranked sub-portfolio)
This example assumes that the general direction of the share market is down, and again, the highly ranked sub-portfolio has outperformed the lowly ranked portfolio, meaning that it has fallen less than the lowly ranked sub-portfolio. In this scenario, a 5% loss has occurred on the highly ranked ‘long’ sub-portfolio, which profits from rising prices, but a 20% profit has been achieved on the lowly ranked ‘short’ sub-portfolio, which profits from falling prices, producing a net profit of 15% overall.

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Note: It is of course also possible for a market neutral strategy to produce a negative return in a rising, falling, or sideways market, i.e. if the highly ranked sub-portfolio underperforms the lowly ranked sub-portfolio. It should also be noted that whilst a market neutral investment is not expected to suffer from a substantial market decline, it also is not expected to benefit from a substantial share market rally. The above examples are purely for illustration and should not be construed as being reflective of any particular expected return or timeframe.

For more information on the Rushton Global Market Neutral Fund, click here.