Equity market neutral is an investment strategy that is employed by many hedge funds in order to provide returns that are independent from the movements of the stock market as a whole. This strategy involves using long and short positions on stocks in order to decrease the amount of dependence on the entire market. Using equity market neutral strategies requires detailed knowledge of stock market sectors, hedging strategies and risk levels.
With most equity market neutral strategies, the hedge fund is going to invest within a particular sector of the market. The fund will not spread the investments out over several industries, in most cases. The hedge fund takes some long positions and some short positions within the same sector. By doing this, the hedge fund hopes that the portfolio will not be negatively affected by circumstances that affect the industry as a whole. The hope is that the long positions are going to perform better than the rest of the sector.
The equity market neutral strategy also is used as a hedge for investors in a fund. Investors of hedge funds typically have to invest large amounts of capital in order to get involved in the fund. This large investment requires the hedge fund managers to build in some protections for the portfolio as a whole. By taking positions in both directions in the market, the hedge fund managers hope they can lower the amount of overall risk for the investors. If the industry goes up or down, the money in the fund should remain intact.
Using an equity market neutral strategy involves a fair amount of risk. Even though the purpose of this investment is to create a hedge against market factors, there still is some room for error. The success of this strategy depends on the ability of the hedge fund manager to choose the right stocks. The hedge fund manager has to choose the stocks that are going to perform better than the rest of the sector.
If the hedge fund manager chooses the wrong stocks for the fund, it could have devastating effects on the portfolio. Any strategy that utilizes active management techniques such as these is inherently more risky than a passive management strategy. Investors in this type of strategy have to have an appetite for risk and put a great deal of faith in the hedge fund manager.