Market-Neutral Investing: Long/Short Hedge Fund Strategies (Bloomberg Financial) [Hardcover]

As Nicholas describes, the market neutral strategy encompasses eight different substrategies that deal with financial instruments ranging from equities, to convertible bonds, and mortgage backed securities. Nicholas dedicates a whole chapter for each substrategy. Within each chapter, he describes how a specific strategy structures its market neutral positions, how it earns its return, and what risks it bears.

Nicholas explains clearly that market neutral investing derives its return not from market movements, but from changes in the relationship or spread between its long positions and its short positions within a certain type of securities.

Market neutral investing consists in observing relationships between similar securities; and taking a long position in the ones that appear underpriced while taking a short position in similar securities that appear overpriced. This strategy is called convergence. The investor bets that the spread between the values of securities he is long and the one he is short will narrow. This entails that in relative term, the long positions are expected to appreciate and the short position are expected to depreciate. Thus, the values of the long undervalued positions and the values of the short overvalued positions should converge over time. That would be ideal. It does not always work out that way. Often, the long and short positions respective values do not converge, but diverge. That is what killed Long Term Capital Management.

The one caveat is that this book comes across as a commercial for market neutral investing. Nicholas convinces you will earn superior risk adjusted returns vs. regular investing strategies. Also, you will benefit from the market neutral strategies being uncorrelated to traditional stocks and bonds markets. Thus, market neutral strategies provide you with diversification benefits.

Regarding diversification benefits, Nicholas is correct. Given that these strategies returns are somewhat independent from market movements in the related securities, it makes sense that they would be uncorrelated to these same markets.

Nicholas assertion that these strategies provide superior risk adjusted return is less convincing. I would not be surprised his data is victim of survivor bias. If you select only the funds that survived during your research period, you ignore all the funds that failed during this same period. As a result, you overstate the performance of this investment style by selecting only the strong survivors. Additionally, his time horizon is too short. On page 7, he graphs the risk vs. returns for different market neutral strategies during the nineties alone. That is not long enough. Granted some of these strategies did not exist for much longer. Thus, we can't tell yet if performance is for real. Also, he states that all these strategies are above the efficient frontier that represents a straight line between the T-Bill risk/return position and the S&P 500 risk/return position. But, the efficient frontier is not on a straight line, but rather on a concave line. If the efficient frontier was graphed correctly, many of the market neutral strategies would be under the efficient frontier.

I am skeptical about the superior risk adjusted return of market neutral strategies because of my own experience. We invested in three such market neutral funds. They had alluring past performance that confirmed everything Nicholas says about such funds. The minute we invested in such funds, their performance mysteriously deteriorated. Somehow, all these funds benefited from convergence before we invested. But, suffered from divergence right after we invested. Within two years, we closed out our investment positions in all three funds, and never regretted it. Thus, I feel that data integrity, and disclosure are real issues in this industry. And, it undermines the credibility of their superior past performance.

My reservation regarding market neutral investing are supported by well publicized failures of some of the biggest funds within this investment style. These include the failure of Long Term Capital Management and the liquidation of the Tiger Funds.

If you want to track how a market neutral fund performs, you can follow one of the oldest AXA Barra market neutral fund (SSMNX). As you will see, the performance is lackluster. And, I believe it is representative of the performance of this sector.

Besides my reservation regarding market neutral investing, this book gives you an excellent foundation on this subject.

If you are a trader, fund manager or other financial professional you might find the material a bit basic, but your clients undoubtedly would benefit from your recommendation of this book. Even those with advanced finance degrees will likely find this book an excellent overview of the rapidly expanding opportunities in alternative investments.