Equity Market Neutral Stock Trading Strategy

What Is Equity Market Neutral?

Equity market neutral (EMN) is a trading strategy that seeks to hedge against directional market exposure by taking offsetting long and short positions. Instead, EMN performance is measured by the spread between the fund's long and short exposures or against a risk-free benchmark rate of return.

Understanding Equity Market Neutral

Equity market neutral describes an investment strategy where the portfolio manager attempts to exploit differences in stock prices by being long and short an equal amount in closely related stocks. These stocks may be within the same sector, industry, and country, or they may simply share similar characteristics, such as market capitalization, and be historically correlated.

Equity market neutral funds have portfolios that are created with the intention of producing a positive return regardless of whether the overall market is bullish or bearish. The term is most closely associated with hedge funds that market themselves as being equity market neutral, and it is sometimes referred to simply by its acronym, EMN.

Equity market neutral funds are intended as a hedge against market factors and is seen as a strategy for stock pickers, because stock picking is all that counts. A hedge fund manager, for example, will go long in the 10 biotech stocks that should outperform and short the 10 biotech stocks that will underperform. Therefore, what the actual market does won't matter (much) because the gains and losses will offset each other. If the sector moves in one direction or the other, a gain on the long stock is offset by a loss on the short.

Equity Market Neutral and Rebalancing

At first glance, equity market neutral funds can look just like long short funds or relative value funds. The major difference is that equity market neutral attempts to keep the total value of their long and short holdings roughly equal, as that helps to lower the overall risk. To maintain this equivalency between long and short, equity market neutral funds must rebalance as market trends establish and strengthen. So as other long short hedge funds let profits run on market trends and even leverage up to amplify them, equity market neutral funds are actively staunching returns and increasing the size of the opposite position. When the market inevitably turns again, equity market neutral funds again whittle down the position that should profit to move more into the portfolio that is suffering.

Equity Market Neutral and Institutional Investors

A hedge fund with an equity market neutral strategy is generally aiming itself at institutional investors who are shopping for a hedge fund that can outperform bonds without carrying the high risk and high reward profile of more aggressive funds. Due to this emphasis on low risk, equity market neutral funds tend to have lower returns than other hedge funds.

It is interesting to note that equity market neutral funds can and do lose money on an annual basis, but it is not usually a significant amount. So institutional investors in equity market neutral funds know they can avoid double digit losses it they come to terms with the fact that double digit returns will be just as rare.

Investopedia does not provide tax, investment, or financial services and advice. The information is presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Investing involves risk, including the possible loss of principal.