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By Jeff Shen, Rich Mathieson, Christopher DiPrimio
Macroeconomic uncertainty has remained front and center in 2023 as the new investment regime continues to play out. Inflation remains above central bank targets and some signs of economic weakness have started to surface in the wake of rapid monetary tightening. The dynamics of stable growth, low rates, and low inflation that persisted in recent decades are now working in reverse, creating a new era of increased market volatility.
The previous macroeconomic regime known as the Great Moderation generally supported stable returns and reliably low correlations between stocks and bonds—making the traditional 60/40 allocation1 an ideal asset mix for many investors. Now, investors may need to rethink portfolio construction by complementing traditional asset classes with new sources of diversification and return. While there’s no one-size-fits-all solution, market neutral strategies may help to improve portfolio outcomes by offering a diversifying return stream with a low correlation to broad asset classes.
As the name suggests, market neutral strategies are designed to target returns that are independent of market direction. Compared to active long-only strategies that invest only in the highest conviction stocks and avoid those with a less favorable outlook, market neutral strategies are able to make both long and short investments.2 As shown in Figure 1, this expands the opportunity set for return generation, allowing investors to express a broader range of active views (positive, less positive, or negative) across each stock in the investment universe.
Figure 1: Market neutral investing expands the investment opportunity setExample opportunity set for a market neutral strategy
Source: BlackRock Systematic, as of May 2023.
A relatively even split of long and short investments results in a net market exposure of zero. This greatly reduces the influence of market fluctuations on the strategy’s returns. Instead, returns are driven by security selection and the ability to effectively forecast the relative return differential between long and short holdings.
In practice, if the short side of the portfolio lags the long side of the portfolio (in line with forecasts), then those positions will contribute to the strategy’s return potential regardless of market direction. Figure 2 illustrates this concept in the event that markets are trending upwards. If Holding A is projected to increase by 12% and Holding B is projected to increase by 2%, an investor would buy A and short sell B to target an expected return of 10% (before factoring in transaction costs) without exposure to the overall market.
Figure 2: Market neutral returns are driven by security selection across long and short positions, regardless of market directionProjected returns of a long position (Holding A) and short position (Holding B)
The spread in performance between long and short positions is where the alpha3 opportunity exists for market neutral strategies. This means that the more variation there is in performance across securities, the richer the opportunity set is for return generation.
In recent decades, an abundance of central bank liquidity and low borrowing costs supported stable returns for most assets and suppressed security dispersion—or the degree of difference in performance across single securities. Now, macro volatility is creating a more dispersed market environment as individual companies differ in their ability to adapt to challenges like persistent inflation and higher interest rates.
Dispersion is a return source that’s not captured in the traditional 60/40 construct. While stock and bond returns are highly dependent on economic and market conditions, dispersion can exist regardless of market direction. Importantly, it tends to be the highest when markets are volatile and uncertain—the very time that 60/40 portfolios need the most help. Figure 3 shows how equity return dispersion has risen above its historical average. As the previous ‘rising tide lifts all boats’ environment appears to have come to an end, the opportunity to take advantage of the relative return differences across securities makes a market neutral approach increasingly compelling.
Figure 3: Equity return dispersion has risen above its historical averageCross-sectional standard deviation of trailing 3-month S&P 500 returns Source: BlackRock, with data from Bloomberg, as of April 2023.
Macro volatility has also shifted the diversification properties of 60/40 portfolios that have been foundational to portfolio construction in recent decades. During the Great Moderation, below target inflation gave central banks the freedom to cut interest rates and ease financial conditions in response to growth shocks. This meant that when stocks would fall, interest rate cuts generally caused bonds to rally and provide a ballast against equity risk.
Now, central banks are limited in their ability to cut interest rates as they prioritize restoring price stability through tighter financial conditions. Figure 4 illustrates how the historically negative correlation between stocks and bonds has become less reliable in a world of high inflation. Over the last two years, bonds have delivered negative returns on average on days when equity returns were also negative.
Figure 4: The ability of bonds to diversify equity risk is less reliable in a world of inflation10-year US Treasury returns on equity down days, 2000-2023
Sources: BlackRock Investment Institute, with data from Refinitiv Datastream, April 2023. Notes: The chart shows the average daily return of 10-year U.S. Treasuries on days when equity prices fell, based on the size of the drop in equity prices. The red bars show daily returns for the period 2000-2007, the yellow bars for the period 2008-2020 and the pink bars for 2021 onwards. All periods start in January and end in December for each respective range. The index used for equities is MSCI World. Past performance is no guarantee of future results.
The degree of diversification that bonds can provide is likely to remain less reliable as the new regime of greater macroeconomic uncertainty persists. By accessing new return sources like security dispersion that are independent of market direction, market neutral strategies tend to exhibit a low correlation to traditional asset classes and even other alternative solutions. This provides the added source of diversification that’s needed in the 60/40 portfolio today.
We discussed the potential of market neutral strategies to expand the investment opportunity set, take advantage of new return sources, and provide an added layer of diversification in portfolios. However, not all market neutral strategies are created equal. In our view, a systematic approach helps to maximize the effectiveness of market neutral investing.
Systematic processes enable granular, data-driven analysis to be scaled across the entire breadth of the market every day. Stocks are then scored and ranked daily, combining into a view of the extent that each security is expected to outperform or underperform on a relative basis. The breadth and speed of analysis allows systematic investors to quickly identify alpha opportunities as they arise across the market. Beyond security selection, systematic processes support the rapid recalibration of portfolios that’s necessary to remain nimble in a more volatile regime.
Finally, investment insights are implemented through a process that explicitly balances return considerations with risk and cost tradeoffs. This helps to limit unintended bets or concentration risks that can surface if not closely monitored. The ability to scale investment insights, capture alpha opportunities, and manage risk exposures makes a systematic process well-suited for market neutral investing.
The benefits of market neutral investing have become increasingly relevant amid heightened uncertainty and volatility. As investors look to evolve the traditional 60/40 portfolio to address today’s challenges, market neutral strategies may help target differentiated return sources like security dispersion to complement existing allocations with an additional source of diversification and return. Taking a systematic approach can help to maximize the effectiveness of market neutral investing—providing the breadth, granularity, and speed that’s needed to capture opportunities in the new regime.
1 The 60/40 portfolio refers to a portfolio where 60% is invested in stocks and 40% is invested in bonds, which is the initial starting point for many investor portfolios.
2 “Going long” refers to investing in securities that are expected to outperform. Short selling or “going short” is a strategy for generating returns when a stock’s price is falling. When an investor goes short a stock, the investor borrows the stock from a lender and sells the stock at the current market price. Next, the investor buys the stock back a lower market price sometime in the future so that they can return the stock to the lender. The difference between the investors initial sell price and the buy price is the profit. For example, if an investor thinks XYZ stock is overvalued at $100 per share, and is going to drop in price, the investor may borrow 100 shares of XYZ from a lender, and then immediately sell it for the current market price of $100. If the stock goes down to $90, the investor could buy the 100 shares back at this price, return the shares to the lender, and net a profit of $1,000 ($10,000 – $9,000). However, if XYZ stock price rises to $110, the investor would lose $1,000 ($10,000 – $11,000).
3 Alpha refers to the excess returns earned on an investment.
Investing involves risks, including possible loss of principal.
Key risks of the fund: This fund is actively managed, and its characteristics will vary. Stock values fluctuate in price so the value of your investment can go down depending on market conditions. International investing involves special risks including, but not limited to currency fluctuations, liquidity, and volatility. These risks may be heightened for investments in emerging markets. The issuers of unsponsored depositary receipts are not obligated to disclose information that is, In the United States, considered material. Investing in long/short strategies presents the opportunity for significant losses, including the loss of your total investment. Such strategies have the potential for heightened volatility, and in general, are not suitable for all investors. The fund may use derivatives to hedge its investments or to seek to enhance returns. Derivatives entail risks relating to liquidity, leverage and credit that may reduce returns and increase volatility. The fund may engage in active and frequent trading, resulting in short-term capital gains or losses that could increase an investors tax liability. Short-selling entails special risks. If the fund makes short sales in securities that increase in value, the fund will lose value. Any loss on short positions may or may not be offset by investing short-sale proceeds in other investments. Investing in small- and mid-cap companies may entail greater risk than large-cap companies, due to shorter operating histories, less seasoned management, or lower trading volumes. Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Asset allocation strategies do not assure profit and do not protect against loss.
This information should not be relied upon as research, investment advice, or a recommendation regarding any products, strategies, or any security in particular. This material is strictly for illustrative, educational, or informational purposes and is subject to change. This material represents an assessment of the market environment as of the date indicated; is subject to change; and is not intended to be a forecast of future events or a guarantee of future results. Reliance upon information in this material is at the sole discretion of the viewer.
The information and opinions contained in this material are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents.
Stock and bond values fluctuate in price so the value of your investment can go down depending on market conditions. International investing involves special risks including, but not limited to political risks, currency fluctuations, illiquidity and volatility. These risks may be heightened for investments in emerging markets. Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Asset allocation strategies do not assure profit and do not protect against loss.
Prepared by BlackRock Investments, LLC, member FINRA.
©2023 BlackRock. Inc. or its affiliates. All rights reserved. BLACKROCK is a trademark of BlackRock, Inc. or its affiliates.. All other trademarks are the property of their respective owners.
This post originally appeared on the iShares Market Insights.
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