What Is a Market-Neutral Investment Strategy?

A Market-Neutral Investment Strategy in Less Than 5 Minutes

Person in yellow sweater and glasses, looking at laptop
•••

LeonidKos / Getty Images

A market-neutral investment strategy aims to provide investment returns that are uncorrelated with the returns of the general stock and bond markets—often by taking an equal position between long and short investments. This type of strategy can be used by investors to try to achieve more diversification.

In this guide, learn how a market-neutral investment strategy works, and what to consider when choosing whether or not to add it to your investment portfolio.

Definition and Examples of a Market-Neutral Investment Strategy

A market-neutral investment strategy tries to provide returns that do not depend on what the general market is doing, typically by taking a neutral position between long and short investments.

With many investment strategies, the whims of the market can drive returns, rather than the investor’s decisions. For example, a fund manager might invest heavily in tech companies, thinking that this sector will outpace an overall market benchmark, like the S&P 500. Yet an economic recession might prompt a wave of investors to sell their stocks and hold cash, causing tech stocks to decline in value just as much as, say, retail stocks—a sector that is generally volatile and unpredictable.

Conversely, an investment manager might short a tech stock, thinking that investor demand has caused the price to go up more than what that manager thinks the company is really worth. However, even if this bet makes logical sense, market events such as a positive GDP report or the Fed lowering interest rates might cause investors to pour even more money into equities, causing that tech stock to rise alongside the overall market.

So, a market-neutral investment strategy aims to avoid these broader market forces and instead provide returns that do not correlate with the overall market. By taking an approximately equal position in long investments (hoping the price goes up) and short investments (hoping the price goes down), a market-neutral investor hedges against market swings in either direction.

If the Dow drops by 10%, for example, perhaps the long positions in that market-neutral investment strategy also fall by 10%, while the short positions rise by 10%. In that case, the strategy returns 0% (assuming an equal weight), instead of losing money. Ideally, though, the investment manager’s choices for both long and short investments perform as predicted, with shorts falling and longs rising, causing positive returns overall.

How Does a Market-Neutral Investment Strategy Work?

A market-neutral investment strategy can often be accessed via investment vehicles such as mutual funds and hedge funds. An individual investor could, theoretically, create their own market-neutral investment strategy, but due to the complexity, one might prefer to invest in a professional manager’s market-neutral fund.

Through the manager’s investment decisions, a market-neutral investment strategy aims to avoid risk by getting beta as close to zero as possible. Let’s take a deeper dive into what that market risk looks like.

Suppose an investor tries to decide between buying Microsoft or Apple stock. While one company might have a better year than another based on revenue growth, the stock prices still might move almost in unison, given that they’re comparable and in the same industry. If investors take money out of stocks, such as by selling off their stakes in large-cap mutual funds, both Microsoft and Apple stock might fall.

With a market-neutral investing strategy, however, an investment manager might bet one of these stocks will rise while the other falls. Hopefully for investors, the manager is right on both accounts. But if an event such as a market sell-off happens, then having that short position could balance out the loss from the long position.

According to Fidelity, a 15% allocation to market-neutral strategies to a traditional 60/40 equity- and bond-filled portfolio has historically resulted in an improvement in the risk and return tradeoff over the past 20 years, as represented by a Sharpe ratio of 6.6%.

Some market-neutral investment strategies use a mix of assets, such as stocks and bonds, whereas others might invest in a single asset class, such as equities. Market-neutral investment managers might then take long/short positions, while perhaps using various financial instruments like derivatives to hedge against market risk. Depending on factors such as the structure of the investment vehicle (e.g., a mutual fund vs. a hedge fund) and the investment manager’s preferences, these strategies also might use leverage, where they borrow money to place bigger bets.

What Does a Market-Neutral Investment Strategy Mean for Individual Investors?

Individuals may want to consider adding market-neutral investment strategies to their portfolios as a way to add diversification. An investor who splits their money between domestic and international stocks, for example, could still be at risk for events like a global recession, causing both types of stocks to fall. Whereas if you take a market-neutral investing position, you might not be exposed to this same risk.

That said, market-neutral investment strategies can still carry risk that investors need to be aware of. For example, an investor in a market-neutral strategy might miss out on some of the gains from big stock market rallies. Market-neutral investment strategies that use leverage, for example, also could face the risk of inaccurate bets amplifying losses.

There is no guarantee a market-neutral strategy will work as intended, as it depends on the methods. For example, a market-neutral strategy that invests in assets like derivatives can be riskier and more volatile than traditional investments. Less-liquid securities can also be difficult to buy or sell.

In theory, an investor could develop their own market-neutral strategy and trade securities accordingly. But these strategies can be complex, and individuals might have limited access to short selling, for example.

In this case, individuals may want to access these strategies through a professional investment manager, such as via a mutual fund or exchange-traded fund. These types of funds often have relatively accessible entry points. Even if there’s an investment minimum, you can find equity mutual funds to invest in for $1,000, for example. In contrast, hedge fund minimums can be hundreds of thousands of dollars, if not more, and typically aren’t accessible to the average investor.

It’s also important to note that investing in market-neutral strategies does not have to be an all-or-nothing decision. For example, an individual might choose to put some money in traditional long-only funds and some money in a market-neutral strategy. Either way, it is smart to maintain a diversified portfolio.

Key Takeaways

  • Market-neutral investment strategies aim to avoid general market risk and provide uncorrelated returns.
  • To achieve a market-neutral investment strategy, an investor often takes an equal position between long and short investments.
  • Some investors use market-neutral investment strategies as a diversification tool.
  • Market-neutral investment strategies can still carry their own risks, just not necessarily the same ones as traditional long-only strategies.