Market-Neutral Strategy
A Category III AIF strategy taking equal long and short exposures within a sector, industry or market-cap segment so that portfolio beta is zero or close to zero.
In plain language
A long-short manager bets on which stocks are mispriced. But it still carries some exposure to the way the whole market moves. A market-neutral manager tries to remove that exposure fully. Then only stock picking drives the result.
The workbook explains that, like long-short, this strategy seeks absolute returns. It too looks for over-priced and under-priced stocks. The difference is that the fund has net 'zero' or 'neutral' exposure. That neutral exposure can be to a sector, an industry or a size band (market-capitalisation) of companies. The manager takes equal amounts of long and short exposure. It goes long in under-priced stocks and short in over-priced ones.
The fund is neutral to the broad index, industry or sector. So its beta is zero or close to zero. Beta here means systematic risk, the risk that comes from the market as a whole.
Managers may pick the positions using fundamental analysis or computer-based (quantitative) algorithms.
How it works
The discipline. The manager must keep portfolio beta close to zero; a high beta signifies greater volatility. So the manager has low flexibility to trade freely across market-caps, industries or sectors.
Computing portfolio beta — the workbook's Example 3 (Fund PQC). Beta is the sum of stock betas weighted by each position's share of the segment's investments:
| Large-cap | Stock beta | Value (Rs) | Weight | Weighted beta |
|---|---|---|---|---|
| Company B (buy) | 0.40 | 5,00,00,000 | 0.25 | 0.10 |
| Company C (buy) | 2.00 | 5,00,00,000 | 0.25 | 0.50 |
| Company D (sell) | 1.20 | (10,00,00,000) | 0.50 | (0.60) |
| Total | nil | 0.00 |
The mid-cap book — Company E bought and Company F sold, Rs 5 crore each, both beta 1.50 — also nets to zero.
Where neutrality slips. The fund also bought a NIFTY50 call (strike 10,000) and a NIFTY50 put (strike 9,500) with the same expiry and the same total contracts. That neutralises index exposure above 10,000 or below 9,500, but not between 9,500 and 10,000, so the derivatives are not market-neutral and overall portfolio beta is close to, not exactly, zero. The workbook accepts that in practice beta will not stay exactly zero, and a beta close to zero is justified if the options are for hedging.
What zero beta does not remove. Individual stock positions still carry unsystematic risk. A zero beta "does not ensure that the Strategy is not volatile or risky, during economic downturns", and excessive leverage and concentrated positions can add volatility.
A worked example
Illustrative figures. Sahyadri Market-Neutral Fund builds a pharma book:
| Position | Value (Rs crore) | Stock beta | Weight | Weighted beta |
|---|---|---|---|---|
| Long Company P | 30 | 0.80 | 0.25 | 0.20 |
| Long Company Q | 30 | 1.60 | 0.25 | 0.40 |
| Short Company R | (60) | 1.00 | 0.50 | (0.50) |
| Total | nil | 0.10 |
The rupee exposure is neutral — Rs 60 crore long against Rs 60 crore short — but the beta is 0.10, not zero, because the stock shorted is less volatile than the stocks bought.
To bring beta to zero, the manager replaces Company R with Company S, beta 1.20:
Weighted beta of short = 0.50 x 1.20 = 0.60
Portfolio beta = 0.20 + 0.40 - 0.60 = 0.00
Two months later Company Q's price rises sharply and its weight in the book grows. Beta drifts above zero again and the manager has to rebalance — exactly the workbook's point that individual price movements "can significantly change the portfolio mix, as the investment manager will again need to bring the Portfolio Beta to Zero".
Why NISM asks about it
Chapter 7 (Category III AIF Investment Strategies and Due Diligence Process) covers the market-neutral strategy at 7.1.3 with the Fund PQC beta computation and options analysis, and contrasts it with the directional strategy at 7.1.4. Chapter 6 uses a market-neutral fund in its benchmarking example, and Chapter 7's sample questions test the difference from long-short. Expect questions on the zero-beta objective, the weighted-beta arithmetic, and why a zero beta does not mean zero risk.
Common exam traps
- Market-neutral = net zero exposure to a sector, industry or market-cap; beta at or near zero. Long-short does not require this. A Chapter 7 sample question attributes net-zero sector exposure to "the difference" between the two — it is a feature of market-neutral.
- Equal rupee amounts long and short do not guarantee zero beta if the stocks' betas differ.
- Zero beta removes systematic risk, not unsystematic risk. Stock-specific moves, leverage and concentration still create volatility.
- A directional strategy is the opposite — it does not aim for a zero or near-zero beta.
- Options with different strikes leave a band of exposure. In Fund PQC, the index between 9,500 and 10,000 is not neutralised.
- The manager has low flexibility to trade freely across market-caps, industries and sectors.
Check yourself
1.What distinguishes the Market-Neutral Strategy from the Long-Short Strategy?
- a)The Market-Neutral fund has net zero or neutral exposure to a particular sector, industry or market-capitalisation
- b)The Market-Neutral fund takes only long positions
- c)The Long-Short fund is prohibited from using derivatives
- d)The Market-Neutral fund is prohibited from taking leverage
Show the answer
Answer: (a) The Market-Neutral fund has net zero or neutral exposure to a particular sector, industry or market-capitalisation
This is the workbook's own sample question, stated as True. The difference in Market-Neutral Strategy is that the Category III AIF has net zero or neutral exposure to a particular sector, industry or market-capitalization, giving a beta of zero or close to zero. The aims also differ: market-neutral funds use long and short positions with the aim of minimizing the systematic risk of the portfolio, whereas long-short funds use long and short positions with the aim of taking advantage of undervalued and overvalued opportunities. Option (d) is wrong — excessive leverage in a market-neutral fund can still increase volatility.
2.A Global-Macro strategy differs from an equity-market strategy because it:
- a)takes positions only in currencies and commodities
- b)takes long and short positions across currencies, fixed income securities, equities, commodities, real assets and interest rate derivatives, selecting on macro-economic trends
- c)avoids leverage entirely
- d)may not be combined with a long-short or market-neutral approach
Show the answer
Answer: (b) takes long and short positions across currencies, fixed income securities, equities, commodities, real assets and interest rate derivatives, selecting on macro-economic trends
Global-Macro funds can take both long and short positions across asset classes such as currencies, fixed income securities, equities, commodities, real assets and interest rate derivatives, and the manager makes stock selection primarily on the basis of macro-economic trends and factors, instead of fundamental analysis of historical data of every company. Option (d) is expressly contradicted: the fund may apply a long-only strategy, market-neutral strategy, directional strategy or a long-short strategy within its global-macro scope — which is why Fund GMS was described as global-macro and long-short.
Where this is taught
Free preparation for NISM Series XIX-BRelated terms
- BetaHow sharply a share moves relative to the market index — beta 1 moves with the index, above 1 amplifies it, below 1 dampens it. The standard measure of systematic risk.
- Category III AIFThe AIF category for funds running diverse or complex trading strategies with leverage — hedge funds and their kin — and the only category denied tax pass-through status.
- Systematic riskThe part of an investment's risk that comes from economy-wide forces moving every asset at once — it cannot be diversified away, and it is the only risk the market pays you to carry.
- Hedge FundA pooled vehicle using diverse or complex trading strategies, long and short positions and fund-level leverage — in India, the AIF Regulations place hedge funds in Category III.
- Directional StrategyA Category III AIF strategy that takes a net long or net short position on stocks or an index, betting on the market's direction; short-bias and dedicated-long are its variants.
- Long-Short Equity StrategyA Category III AIF strategy that buys stocks the manager thinks are under-priced and shorts those it thinks are over-priced — often run as a 130/30 fund with 100% net market exposure.
- Global-Macro StrategyA Category III AIF strategy taking long and short positions across currencies, fixed income, equities, commodities, real assets and interest rate derivatives, driven by macro-economic trends.
- Short-bias StrategyA directional strategy in which the manager holds both long and short positions but keeps a net short exposure to the broad market, so the fund benefits when the market falls.
- Long-only Equity StrategyA Category III AIF strategy that takes only buy positions in selected stocks when investing, aiming at absolute returns over the medium to long term with a strong emphasis on capital preservation.
- Absolute-return StrategyA Category III AIF strategy that aims to make money independent of broad market moves, using leveraged, concentrated, long/short or market-neutral positions, and benchmarked to a fixed rate rather than an index.
- Portfolio betaThe weighted average of the betas of the holdings in a portfolio — the measure of its systematic, non-diversifiable risk used in CAPM, the Treynor ratio and market-neutral strategies.
- Borrowing feesThe fee a fund pays to borrow securities so that it can take a short position — an additional cost of the short, quite separate from interest on borrowed cash.
- Offsetting positionsNetting a Category III AIF's long and short positions in the same stock, index or commodity with the same maturity, so that its leverage is measured on net rather than gross exposure.