Please explain to me how equity market neutral funds work? understand, experience, however, factors, limited

kmf229

Hi guys,
I’m working CFA level 2, however, my experience is very limited. Can you explain me how equity market neutral funds (EMNF) make profits?
As I know, EMNFs try to match the size and beta of long positions with the size and beta of short positions. At the same time, they take substantial risks in other equity factors such as capitalization, value, growth…
What I don’t understand is that how can these funds make profits when the long positions are almost perfectly matched by the short positions?
It would be grateful for me to be illuminated. Thank you very much.

ba736

you are right in that they work with long-short pairs such that the fund is insulated from overall market movements (Beta) and captures only the stock specific movements (Alpha).  Here’s a good example using just two stocks:  Apple and RIM (Blackberry maker).  You feel the iPhone is going to be a big hit and that it will take the market from Blackberry so you go long Apple and short RIM.  Your bet is that Apple will go up and RIM will go down.
The amount you go long each is dependent on their Beta.  If they each had a Beta of 1 then you would buy the same amount of each (say $1000).  If they each had different Betas then you would buy a proportion of each that made the total Beta of the long/short pair equal to zero.
So now it is a couple of months down the line and the market in general is selling off.  You are protected from the overall market selloff because your loss on Apple (long position) is offset by your gain on your RIM short.  
Now fast forward a year or so and the overall market hasn’t budged much yet your Apple stock has gone up 100% and your RIM stock has gone down 85%.  This means that you made a gain of 100% on your Apple long and a gain of 85% on your RIM short such that your overall gain is (100 + 85)/2 while the market barely budged.  But even if the market did fall or rise generally, you have neutralised that effect on your portfolio to get just the stock specific risk.
This assumes that fundamentals win out.  What we have been seeing since 2009 is that there have been many periods where all sectors and stocks rose and fell in virtual unison which, in the short run, screws up the market neutral guys but in the long run (as in the RIM/AAPL example) fundamentals should win.

chunty

trimonious2 wrote:
you are right in that they work with long-short pairs such that the fund is insulated from overall market movements (Beta) and captures only the stock specific movements (Alpha).  Here’s a good example using just two stocks:  Apple and RIM (Blackberry maker).  You feel the iPhone is going to be a big hit and that it will take the market from Blackberry so you go long Apple and short RIM.  Your bet is that Apple will go up and RIM will go down.
The amount you go long each is dependent on their Beta.  If they each had a Beta of 1 then you would buy the same amount of each (say $1000).  If they each had different Betas then you would buy a proportion of each that made the total Beta of the long/short pair equal to zero.
So now it is a couple of months down the line and the market in general is selling off.  You are protected from the overall market selloff because your loss on Apple (long position) is offset by your gain on your RIM short.  
Now fast forward a year or so and the overall market hasn’t budged much yet your Apple stock has gone up 100% and your RIM stock has gone down 85%.  This means that you made a gain of 100% on your Apple long and a gain of 85% on your RIM short such that your overall gain is (100 + 85)/2 while the market barely budged.  But even if the market did fall or rise generally, you have neutralised that effect on your portfolio to get just the stock specific risk.
This assumes that fundamentals win out.  What we have been seeing since 2009 is that there have been many periods where all sectors and stocks rose and fell in virtual unison which, in the short run, screws up the market neutral guys but in the long run (as in the RIM/AAPL example) fundamentals should win.
I see! That’s a fantastic explanation. Thank you very much!

LorrinCFA

The theory is great.  In reality, when you actually try it, the stock you are long goes down and the stock you are short goes up.