Tuesday, February 5, 2008

An idiot's equity market neutral fund

Here is a simple way of do-it-yourself way of making an equity market neutral fund without having to pay the big fees:

  1. Buy the top large cap Growth and Value equity funds, as ranked by Morningstar
  2. The funds must be no-load mutual funds, have assets of at least a billion dollars and expense ratios less than 1%
  3. Short the S&P 500 Spyder (SPY) against the portfolio
  4. Re-balance the dollar amounts allocated to the funds monthly and re-balance the fund components annually

For the period from December 1998 to Janaury 2008 the synthetic equity market neutral portfolio showed a very respectable annualized return of 6.4% (after fees) and a Sharpe ratio of 0.9. Comparing to the HFRX Equity Market Neutral Index using that index's inception date of March 2002, this portfolio returned 4.5% vs. the HFRX return of 0.6%.

I have been running this simple portfolio out of sample for since December 2003 and the results are similar to the in-sample results. In 2007, the synthetic market neutral portfolio also beat HFRX with 6.8% to 3.4%.

Sometimes the simple solutions are the best.


Thomas said...

I'm confused...you're trying to be long mutual fund manager alpha here?

Cam Hui, CFA said...

TJ - Alpha is where you find it.

I am turning a mutual fund manager alpha into a "pure" alpha by shorting the market against the long mutual fund position.

Karl Keller said...

Questions: which funds did you use? How many? and Did you equal dollar weight that part of the portfolio?

Presumably you're using 5-star funds. If a Fund drops to 4, do you dump it an buy a 5?

Cam Hui, CFA said...

Equal weighted 5 star funds. The components of the portfolio are re-balanced every January so if a fund drops to 4 stars it gets dropped in January but not before.

Karl Keller said...

Ok, you said "top large cap Growth and Value equity funds, as ranked by Morningstar<'

So, if you don't mind, be specific. How many funds, and which ones? 10 funds? 20 funds? If you could, name names?

I guess I want to see the realism of this strategy. If there are 25 5-star G&V funds, each with a $2500 minimum, you're looking at $75K minimum to implement this strategy.

Cam Hui, CFA said...

There are usually about 5 funds in the value and growth groupings. The weights of the value and growth are made to be equal so that there is no style bias in the portfolio.

There is no doubt that fund minimums will create restrictions as the the minimum size of this strategy. However, this was built as a equity market neutral hedge fund substitute and if you are not at that level of sophistication and size you shouldn't be really involved in hedge fund-like strategies in the first place.

Unknown said...

Very interesting post and blog.

In the spirit of simpler being better, what was the total S&P 500 return over the two time periods mentioned?

Cam Hui, CFA said...


Since this is an equity market neutral fund, using the S&P 500 as a benchmark is inappropriate.

You might as well ask what the bond market or emerging market equities did over the same period - it's not relevant.

Thomas said...

How do you know you're actually capturing alpha here? That is, how do you know you're not exposed to some risk factor that you're getting paid to hold (or even varying risk factors, since you're continually rebalancing)?

Cam Hui, CFA said...


I suppose that you never know that if you are exposed to some beta that you don't know about. However, I am controlling for risk in a number of ways:

1) Market cap - all funds are either large cap growth or large cap value funds
2) Style - half the funds are growth and half are value

Re-balancing is relatively infrequent. The mutual fund components are re-specified annually and $ re-balanced monthly. The results actually aren't that different if you don't dollar re-weight monthly but I thought it was a better way to control risk and not allow the bets taken by the mutual fund managers enjoying short-term success to overly dominate the portfolio.

Unknown said...

Thanks for the public service!
I just had a few questions:

1) The graphical performance results are encouraging, but do you happen to have a year-by-year breakdown of returns? This is useful to know as consistency of performance is desirable.

2) What are the mechanics of shorting SPY - how do I do it?
How would you compare that with just owning an inverse ETF (e.g. proshares, rydex) - e.g. is it cheaper?

3) Why Morningstar 5 star funds for the long positions? I thought Morningstar ratings weren't good forward-looking predictors of performance?

Unknown said...

How practical would it be to apply the same approach to US smallcaps? Internationally? The former seems feasible, but there might be too much tracking error in the funds relative to the short position in the latter.

Matthew said...

Very interesting post. I have explored a similar strategy using ETFs: FDV for the long position and SDS for the short position. FDV is a value strategy based on the largest S&P 500 companies - it appears to generate persistent alpha.

The nice thing is that FDV and SDS both pay dividends, instead of the short position costing you dividends. I used a ratio of about 0.75 SDS to one part FDV.

Another strategy I have considered is going long small value stacks and short small growth stocks. This should perform well over longer holding periods, but would be more volatile than the alpha capture strategy.