Trading Risks in International Investments

7:52 PM Investment Risk 1 Comment

Relative value and market neutral programs, also commonly known as long short programs. Are among the most intellectually appealing and widely misunderstood investment strategies. They seek to attain low volatility profits in rising or declining markets. Essentially, the strategy entails the construction of a portfolio of long and short positions. The portfolio profits if the manager’s relative valuation leads to a rise in the value of the long positions and or a decline in the value of the short positions. Relative value strategies differ from “directional” investment, in which the gain or loss comes from the rise or fall in price of a single asset rather than the relative movement of two or more assets.

Closely related to relative value programs are market neutral programs. Market neutral  portfolios are constructed so that the portfolio’s assets are relatively insensitive to the up and down movements of major markets, whether stocks, bonds, currencies, or commodities. In contrast to relative value, where two or more offsetting assets are meant to neutralize or reduce risk, market neutral strategies reduce risk to a wider market movement.

In theory, market neutral investments should be less risky than relative value investments, since they afford protection against large scale market movements. In practice, however, market neutral strategies tend to be more highly leveraged, reducing the difference between the strategies.

Given the recent upheaval at long term capital management, it might appear inappropriate to place relative value and market neutral strategies in a section on risk management methods. In their genesis and in practice, however, these strategies are meant to reduce the risk of investments. Relative value models are used to statistically measure the historical correlation between the prices of related assets, be they bonds, stocks, or currencies. Often, the analysis shows a  divergence from historical price patterns, presenting an opportunity to profit from the reversion of prices to historical norms. At other times, the calculation is based on the assumption that prices and relationships will remain stable, allowing a profit from the differential in yield between assets. In recent years, examples of the former include buying Italian government bonds and selling German government bonds, looking to profit from the convergence of interest rates as the European markets converged. An example of the letter would include the purchase of mortgage securities hedged by U.S. government bonds, the goal being to lock in the interest rate differential.

The attractiveness of market neutral and relative value strategies is their “built in” hedge. If properly structured under the right market conditions. These spreads are able to produce relatively low volatility returns in a wide range of market conditions. There are many types of market neutral and relative value strategies.

Problem with Market Neutral Strategies

       It is obvious that market neutral and relative value strategies also have some severe problems. Both in theory and in practice. Many of these problems have to do with the trading and execution of relative value positions, especially during times of market distress. One of the most baffling aspects of the Asian crisis of  1997-1998 was the speedy turnaround in the investor’s perception of risk and, consequently, of risk premium. This change led to a dramatic increase in the spread between higher and lower risk assets and to divergences between assets that had previously moved in the same directions.