Beta neutral is a flavor of the ever-popular long/short equity strategy, dictated by beta, or the degree of correlation of volatility between the portfolio and market. Managers enter into long and short trades such that the net beta of all positions is zero, with the goal of creating a portfolio uncorrelated with the movement of the market.
Q. So, this concept is important in the world of long/short arbitrage, right?
A. Yes. There are many kinds of long/short strategies; some have a “long bias”, where the manager thinks markets overall will rise; and some have a “short bias”, which is obviously the opposite. And then there are true “market neutral” funds that really are, in principle, indifferent to the overall direction of the markets.
Q. So the overall portfolio should behave exactly as the market does?
A. Right. But doing that is a little more subtle than it first seems. First, as you know, Modern Portfolio Theory (MPT) is very concerned with the idea of how closely a stock’s movement tracks the overall movement of the markets. A security that moves exactly as the market does has a beta of one; a stock that is more volatile has a beta greater than one; one that is less volatile, has a beta of less than one.
Q. Ok — so how do you translate that into an equity neutral portfolio?
A. Well, you want to balance out the longs and the shorts so that, when you add up their volatility, they are “beta neutral”: the portfolio shows a beta of zero. But there are also a couple of other “neutrals” that you can pay attention to. If you have equal dollars invested in both sides of the book, its “dollar neutral. That means there is no net investment.
Q. So… with all that neutrality, how do these strategies actually make money?
A. The key is simple: really great stock selection. The superstar managers in these strategies find pairs of stocks which act as hedges to each other, but where there will be opportunity to profit from their comparitive performance.
Q. But it does sound like a safe sort of way of playing the markets…
A. Certainly the idea is that there’s a lot less exposure to sudden market downturns. But the one thing to keep your eye on is the costs of running portfolios like these… keeping things truly beta neutral can involve a lot of trading because the stocks’ betas keep changing.