Market Neutral Investing

Finn, Mark T.
August 1998
Journal of Financial Planning;Aug1998, Vol. 11 Issue 4, p76
Academic Journal
This paper describes market neutral investing and summarizes the issues that financial planners should consider in determining the proper role for a market neutral strategy. Market neutral investing is an investment technique that combines the purchase of undervalued securities with the short sale of overvalued securities in such a way as to neutralize the impact of the overall market for that type of security. The manager identifies undervalued stocks and overvalued stocks. He or she purchases a portfolio of undervalued stocks so that the portfolio of longs has the same risk characteristics as the portfolio of stocks the manager has identified as overvalued. The portfolio's return is determined by the interest earned on the cash collateral plus the differential performance between the long portfolio component and the short portfolio component. One potential negative aspect of market neutral investing concerns possible tax consequences. Another complication is that market neutral strategies will have higher turnover. Another important issue is the distinction between ordinary income and long-term capital gains. The most obvious risk is that the manager may not possess any stock selection skill. If the portfolio does not have a beta close to zero, it will not be market neutral. While beta attempts to measure the systematic or market related risk, one cannot ignore exposures to common factors. Also consider that the risk of a market neutral manager is all risk specific to the particular manager. A portfolio of several market neutral managers might be the most efficient asset choice of all.


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