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Are factors the key to being market neutral?

Are factors the key to being market neutral?

Neutrality is in short supply on most of today’s pressing issues, with one possible exception.

Those unwilling to decide whether the long equity rally will continue can instead opt for a market-neutral approach, whereby a long/short portfolio is constructed such that each side should offset much of the other’s performance, resulting in modest incremental gains and low volatility.

However, neutrality is far from guaranteed. The success of these strategies depends, whether executed on a quantitative or discretionary basis, on country, sector, and stock selection – being long or short the right securities to the right degree at the right moment.

This explains the wide dispersion in the performance of the actively managed funds in Citywire’s market-neutral sector. While the average fund has returned 1.7% over the past year, the best has generated 11.1% and the worst has lost 6.3%.

A newly launched ETF will give investors a passive alternative, though, by focusing on factors rather than individual stocks.

The Amundi iStoxx Europe Multi-Factor Market Neutral ETF will essentially have two positions: it will be long a six-factor equity index, spanning carry, low risk, momentum, size, value, and quality; this will be balanced by short exposure to a large-cap European futures index.

In theory, this methodology should harvest the risk premia from the factors but strip out the market direction. Investors must hope that this factor alpha is greater than the fund’s ongoing charges of 0.55%, with the index rebalanced every week.

Short of the rally

Over the past year, that has not been the case. The iStoxx Europe Multi-Factor Market Neutral index – so, before the ETF’s fees have been taken into account – lost 3.5% in the 12 months to the end of October while European equities surged by 20.4%.

Put simply, the principal factor worth owning in this rally has been beta – and this market-neutral strategy has been short it.

More encouragingly, the index has broadly delivered what would be expected of a market-neutral fund over long timeframes. It has returned 17.5% and 31.2% over three and five-year periods respectively, compared with 29.6% and 72.6% from the Stoxx Europe 600 index, but with only around a third of the market’s volatility.

It also posted a positive number in the only recent calendar year when European equities ended down, in 2011.

Bearish appeal

The new Amundi ETF, then, should appeal primarily to those bearishly disposed to European equities. Should the European Central Bank remain accommodative – the central bank is tapering but also extending its asset purchases, and president Mario Draghi has committed to additional stimulus if the outlook deteriorates – being simply long Europe may be the better bet.

More broadly, investors seeking to make a passive market-neutral allocation will struggle unless they are prepared to time the market or to accept some stock-picking manager or algorithm.

This is because a market-neutral portfolio has to be long something and short some other thing, which in practice means either active security selection or structural exposure to and against some factors.

The Amundi ETF is thus long factors and short the market, while active market-neutral funds tend to rely on their managers’ assessment of what to be long and what to be short.

In the US, there are no multi-factor market-neutral ETFs but there is a range of single-factor products branded as being market neutral. In reality, these are more like factor portfolios in the traditional academic sense: they are long stocks exhibiting the factor and short those without that factor’s characteristics.

This makes them market neutral insofar as they depend on, say, cheap stocks outperforming expensive ones or high momentum beating low momentum rather than the overall direction of the market. But that of course just means they are reliant on their factor being in favour: the market-neutral anti-beta index has lost money over the past year, while the market-neutral value index is down over three years.

‘Market neutral’ is perhaps therefore the wrong term for these approaches; ‘beta neutralised’, for instance, could be more appropriate for the new European ETF.

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