19-EquityPort Page 575 Friday, March 12, 2004 12:40 PM
Equity Portfolio Management 575Market-Neutral Strategies and Statistical Arbitrage
Market-neutral strategies are portfolio management strategies aimed at
obtaining a positive return regardless of market conditions; a typical
way to achieve this result is long-short equity portfolio management. In
general, a market-neutral strategy will specify four elements:■ Market neutrality is normally defined as lack of correlation with some
broad index such as the S&P 500.
■ The return objective varies in function of market conditions. In a bear
market, a market-neutral strategy might be happy with a modest 5%
return while double-digit return rates might be required in normal con-
ditions.
■ In general, return volatility bounds are set low, significantly lower than
the market volatility. Often this requirement is imposed by central
banks.
■ A maximum draw-down.The above requirements might seem contrary to finance theory as
they appear to violate the risk-return trade-offs of efficient markets.
They might also seem contrary to common sense as conservative pre-
scriptions for volatility and draw-dawns are coupled with aggressive
return objectives. The only possible response to these criticisms is that
market neutral-strategies represent only a small fraction of the market—
those pockets of inefficiency inevitable in (and perhaps instrumental to)
a large efficient market.
Let’s now describe statistical arbitrage, a method used to obtain
market neutral strategies. Statistical arbitrage exploits the existence of
small probabilistic profit opportunities that become nearly deterministic
on a large scale. It was made possible by the diffusion of electronic
transactions that have greatly reduced transaction costs. Obviously
transaction costs and bid-ask spreads might reduce profit opportunities
to nearly zero or even cause losses.
To understand the working of statistical arbitrage, recall that in the
limit of a large economy and under the assumption that it is possible to
completely diversify portfolios, the APT conditions are valid. Recall
also that the APT conditions are represented by zero intercept. The
same condition is valid in the case of single-factor CAPM. As a conse-
quence, if a large number of non-zero intercepts exist, then large profits
can be made with zero initial investment and little risk.
To demonstrate the above, we start with a single-factor market
model with nonzero intercepts: