| The Theory of Market Neutrality |
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“We hold balanced portfolios in each country, i.e., portfolios very close to being equally long and short. Our trading models tend to buy stocks that are recently out of favor and sell those recently in favor.”
James Simons on Pairs Trading
Founder and Chief of Renaissance Technologies, Medallion Fund
November 2009, testifying before congress
Why Market Neutral
Last week we dove head first into the strategy of buy-and-hold and tried to determine if buying stocks and holding onto them for long periods of time is the best way to invest in the stock market. We found that although it is possible to profit off of the buy-and-hold strategy during certain periods, too many factors, such as timing and stock selection, have to be perfect in order to consistently profit off of the buy-and-hold strategy.
We also determined that when it comes to the stock market an investor must decide if they are going to be an active or a passive investor. Our research shows (as does the great Jack Bogle’s) that if you choose to be a passive investor you are better off picking a few indexes such as the S&P 500 or the Russell 2000 to invest in rather than half heartedly picking stocks you think will go up over the long term.
However, if you choose to be an active investor like us then you need to arm yourself with a strategy that has the ability to profit in both up and down markets as well as markets with extreme volatility. The fact the market has gone absolutely nowhere over the last 12 years has caused a lot of passive investors to start thinking about active strategies. We also believe you can get better risk-adjusted returns, more diversification, and protect yourself from large market swings by employing the right active equity strategy.
After 25 years of researching and implementing trading strategies in the marketplace, we’ve found that one of the most effective market neutral strategies is one called “Pairs Trading.”
Let’s clear up some definitions
Through The Draconian and our monthly investor newsletters you have probably heard us use the terms Statistical Arbitrage, Pairs Trading, and Market Neutral. Although these sound like three totally different strategies, they’re basically the same thing.
Here’s why:
Our trading philosophy is very simple. We believe in the world of statistical arbitrage, which consists of finding small inefficiencies in two similar securities and profiting off these inefficiencies. It’s called Statistical Arbitrage because the price discrepancies are statistical in nature. It can take hours, days, or months for these inefficiencies to correct themselves; to us it does not matter. Our goal is to establish a consistent set of rules that finds and exploits these inefficiencies on a daily basis.
The method we choose to expose these inefficiencies is through pairs trading. We find two securities that are in the same sector and highly correlated to each other and we buy the security that is undervalued and short the security that is overvalued. When the two securities have converged, we look at other pairs to repeat the process. Pairs Trading is a flavor of Statistical Arbitrage.
Finally, by exploiting these inefficiencies in the equities, futures, and currency markets this makes our portfolios market neutral. Which is a simple way of saying we don’t care what the overall market is doing, it can go up like the 1990’s tech boom, or it can crash like 2008. We only care about our “Pairs” and the fact that our long position makes more than our short position, or vice versa.
So from here on out we will talk about “Pairs Trading” as our choice for establishing a market neutral portfolio.
The goal of Pairs Trading is to produce positive returns in any market environment, while reducing the volatility of the overall portfolio dramatically. Using the Pairs Trading approach is focused around the belief that, at any given time, multiple stocks are priced incorrectly. It is a little-known strategy with investors at home. The success of it depends completely on the ability to correctly identify these stocks that are undervalued and overvalued.
Fundamental vs Quantitative Analysis
There are numerous strategies, time periods, and variables that you can use to make your portfolio market neutral through pairs trading. You can use fundamental analysis on individual stocks or industries, sort of like what Jeffrey did in The Trade of the Decade. In order to determine what the market thinks about a company you must establish some common measures of value to compare companies against each other. The most popular fundamental measure for doing this includes the price-to-earnings ratio, price-to-sales ratio, price-to-book ratio, and forward price-to-earnings ratio. If you pair some technical analysis with that fundamental research you can get an even better edge at determining the best pairs for your portfolio.
Because of the high correlation that all asset classes have shown over the past few years and all the government intervention in the private sector, we believe a more efficient and effective way for finding pairs trades is through the use of quantitative analysis. Quantitative Analysis utilizes computers, mathematics, and statistics to sort through thousands of possible trades per day. Based on different technical indicators like standard deviations, correlation coefficients, and profit factors, specially designed computer programs can find inefficiencies in the market place and exploit them throughout the trading day or trading year.
A simple example
I think it’s easiest to understand all these concepts with an example.
Here is a sample pairs trade featuring two stocks, Alpha Airlines and Jumbo Jets. They both are in the same sector and since they are each subject to the same set of economic inputs, their stock tends to trade in very similar fashion. They tend to go up and down at the same times.
Here’s what’s happening in that chart:
A. In the early periods and through prior history, the correlation between AA and JJ is very high. They each move up and down together.
B. Something strange happens in Period 5 and they start moving in different directions. AA goes up and JJ goes down. Alpha Airlines is getting a little overvalued and Jumbo Jets is getting more undervalued.
C. The relationship continues to stretch through Period 6 and a trade signal is generated. We buy the undervalued company, Jumbo Jets, and we sell short the overvalued company, Alpha Airlines.
D. As the historical relationship normalizes in Periods 7-9, the system produces a profit and the trade is closed. During the green period when we have the trade on, Jumbo Jets has outperformed Alpha Airlines.
The neat thing about this example is that this hypothetical mini-portfolio is 50% long and 50% short. If the market crashes tomorrow, we’ll lose money on our long position but we’ll make a similar amount of money on our short position. If the government comes out and promises to subsidize every passenger’s airfare and the entire airline industry rallies, our portfolio will again be protected from that volatile spike.
What makes this system profitable is ability to identify the right trades. It’s an entirely skill based trading strategy.
What are the advantages?
1. Low Correlation to the Market
Since 2008 there has been an increasing correlation in most asset classes and trading strategies compared to their historic norm. Historically, market neutral strategies such as pairs trading have had one of the lowest correlations to the overall stock market. This means that market neutral strategies are not dependent on what the market is doing to make money. Those of you that have actually been invested with our firm since the 80’s and 90’s know that our #1 goal is to try and make money whether the markets go up or down. Pairs trading is one more tool that gives us this ability.
2. Higher Risk-Adjusted Returns
Pairs trading allows you to get a high rate of return relative to the amount of risk that you take. Being long $100 of a stock and short $100 of a stock in the same sector creates a reasonable hedge. If the market falls 10% in one day your long stock will lose a lot of money but your short stock will make as much money, perhaps even more than the amount you lost.
Pairs trading strategies provide great protection against broad market swings. When the market is moving down a well-constructed market neutral portfolio will not show as much of a loss as the market indexes and could even show a gain if the portfolio manager is skillful. Conversely, when the market is moving up a good market neutral portfolio should show a gain but most likely it won’t be as much as the market index.
3. Lower Volatility
The current volatility in the markets over the last few years has been at an all time high. Since the Pairs Trading strategy is designed to have close to zero correlation to the overall market, Pairs Trading strategies can provide relatively low volatility during periods like the bear markets of 1997 and 2002, or sharp rallies to the upside like 2009. Not only is Pairs Trading a natural hedge your portfolio, but it has the ability to consistently outperform the market without the use of leverage.
Here’s a chart of the HFRI Equity Market Neutral Index vs. the S&P 500. The HFRI Equity Market Neutral Index contains a lot of different market neutral strategies, and since it’s a benchmark, it contains a lot of strategies that aren’t very good. But it’s still good enough to use as an example.
This chart measures rolling 12-month rate of return for each index.
As you can see, the market neutral line is a lot smoother than the S&P 500. Market neutral actually made money as the dot-com bubble was deflating and it was still modestly profitable when the stock market came rallying back. This market neutral index lost a little bit of money during the financial crisis but it wasn’t anywhere close to what the stock market lost. It wasn’t even a 10% loss! These strategies have also been profitable over the last year.
If you add up the total amount of money made and lost over the last decade, market neutral did pretty well. From 1997 until now the HFRI Market Neutral Index rose a total of +97%. The stock market, as we all know, is right back around where it was twelve years ago.
Now you can see why we get so pumped up about market neutral strategies!
Let’s recap
Market neutral strategies are a really great idea in theory. In practice, pairs trading is a very effective and simple way to implement it. There are lots of ways to do it but we prefer statistically-based systems in our own trading.
For professionals, this sort of strategy is easier to implement. We actually use it in one of our funds. The drawback for the individual is that it to do it effectively it requires a fairly robust trading infrastructure. We have a computer programmer devoted full-time to research and system development. And at any given point in time we may have several hundred different positions on. For a firm like us that isn’t so bad, but for the average investor at home it can be a little difficult to manage a portfolio of that size.
Just because it can get a little complicated, we don’t think that individuals should avoid it altogether. As I said there are a million different ways you can do it. You can trade one pair at a time or you can trade several hundred pairs at a time. It doesn’t need to be anything more complicated than saying “I think Ford is a better company than GM.” Jeffrey has talked about this in the past — the way a lot of the big boys trade is with relative value strategies. A lot of the investors at home don’t understand the concept of relative value.
Finally, this does involve shorting stocks, which carries a set of risks that you’ll want to talk to your financial advisor about. But on balance, a market neutral strategy like this can be a great way to reduce volatility in your investment portfolio. It’s worth discussing it with your financial advisor and if he’s a good one he’ll listen to you about it with an open mind.
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