Traders take positions in pairs of similar stocks, longing the “undervalued” one and shorting the “overvalued one”, thereby placing a bet on the ultimate outperformance of the long position.
We now turn to equity trading strategies that attempt to decouple market movements from portfolio returns. Traders take positions in pairs of similar stocks, longing the “undervalued” one and shorting the “overvalued one”, thereby placing a bet on the ultimate outperformance of the long position. By using equal dollar investments on each member of the trading pair to effect an overall neutral long/short position, the trader is looking to remove beta as a factor affecting portfolio performance. The pair of stocks is usually composed of close competitors in the same market, and therefore presents the same country risk, currency risk, market capitalization risk, etc. By attempting to limit risk exposure to the relative merits of the two stocks, hedged equity market neutral strategy (HEMNS) can be equally attractive in up and down markets.
HEMNS is usually considered a long-term strategy, and may utilize a mix of fundamental and technical analysis. An alternate form of HEMNS is statistical arbitrage (stat arb), in which the pair of positions is determined through the use of technical and quantitative analysis. The goal is to take positions in which a traders proprietary algorithms show a pair of stock to be temporarily mispriced (one too high, one too low); the trader is betting that the stocks will shortly revert to their mean price, at which point the trade is liquidated.
In this example, the trader opens the position with equal dollar amounts of a pair of closely-related auto parts stocks. During the period, each stock pays a dividend. The position is put on for 90 days. Each stock pays a dividend during the period. After accounting for transaction costs, financing costs on the short position, and dividend payments, the strategy provided an annualized return of over 42%. (This is for purposes of illustration only).
For HEMNS to work, there must be a short-term suspension of the efficient market hypothesis (EMH), since a profit opportunity only arises if there is a difference between a stock’s theoretical fair market value and its current price. However, there can be multiple factors at work in HEMNS besides “incorrect” pricing. For instance, style risk arises from choosing assets according to value, capitalization, or momentum. There are also risks due to liquidity, leverage, interest rates, etc. Since each of these risks are rewarded by specific premia, it may be difficult to say for certain that HEMNS returns are due solely or even largely to an asset manager’s ability to differentiate overvalued and undervalued stocks. Such ability, if consistently manifest over time, could be termed alpha, as it may signify returns due to a manager’s skill, not just risk exposure.
However, studies of several paired-equity styles, such as high-value/low value, winning momentum/losing momentum, and small cap/large cap, have shown systematic risk premia available that are not captured by the standard CAPM, as we have discussed in previous articles. Some argue that these risk premia are due to factors like recession risk, bankruptcy risk, and liquidity risk. Others favor behavioral finance, which claims that market inefficiencies are due to suboptimal investor decisions, as an explanation. Investors may not really care, as long as returns are good.
Later on in this series, it will be our task to see if we can replicate HEMNS results without any special stock-picking skill. But we have many more strategies to examine first. We will continue our tour of hedge fund strategies next time with equity hedged short selling.