Within the funds world there are many interesting strategies that are used by managers to provide diversification or outperformance over the mainstream funds in the traditional asset classes. One such concept of is that of market neutral funds. These aim to deliver returns without taking a significant “long” position in equities, bonds or any other asset class. This strategy has a lot of appeal since it does not generate excessive volatility and is largely uncorrelated with more conventional market funds.
Side-stepping market direction
A related strategy to market neutral is known as absolute return, which seeks to earn a constant target return that is significantly in excess of the risk-free rate but independent of market performance. These two definitions are very closely connected, since if an absolute return fund is aiming for a return that does not depend on the market then it cannot be taking a significant fixed position in it. We can also deduce that both these strategies are likely to place a strong emphasis on risk control. This is because the principal source of fund volatility comes from the market holding that it has, so if this has been largely eliminated and the manager is looking for outperformance or arbitrage opportunities between different assets we would expect lower volatility and a more targeted approach.
Market neutral funds have been around for decades but tend to recede in interest and popularity during bull markets. Despite the brief sharp market falls in 2020 in the medium term this is an environment we find ourselves in, particularly in US equities which have more than tripled in the last ten years, therefore market neutral funds have struggled to maintain popularity except in very niche situations. In August 2021 Aviva announced the closure of its flagship absolute return fund after further significant investor outflows.
Structured products that fit this view
With the rich variety that structured products have there are several product types that can achieve outcomes close in spirit to market neutral strategies. Additionally most structured products put a high emphasis on capital protection and risk reduction placing them in a similar bracket.
The three common structured product types that have the highest market neutral flavour are the Dispersion, Range Accrual and Twin Win.
Playing outliers versus the trend
Dispersion products measure the average difference between stocks in a basket or index and the same basket return over a given period. This can either be done with reference to price levels at the end of the product term or to volatility measures. In both cases the strategy is market neutral and is explicitly betting on the correlation between the stocks being lower than expected which would drive these dispersion effects since the product would benefit from overall market neutrality with the basket unchanged but half the stocks going up and half going down. From an investor’s perspective the product type allows a direct view on correlation and the rationale of the product type for the investment bank is to reduce correlation exposure typically built up through worst-of and basket products.
Staying within a range
Range accrual products generally pay income if the underlying asset stays within a predefined range during each coupon period. This range is often symmetric around the initial level of the underlying and therefore the product payoff is maximised if the underlying does not move significantly which is also indicative of market neutral properties. The Twin Win (or dual direction) concept pays if the index is significantly up or down, at least within a given range.
All three of these product types are essentially market neutral but can be thought of precisely in terms of properties such as volatility and correlation, much in the same way as smart beta relies on advanced “factors”.
How to retain some market neutral concepts elsewhere
Other popular structured product types have some properties in common although they are not purely market neutral. These include the defensive Auto-call and Bonus products.
A defensive or step down Auto-call features Auto-call levels that reduce over time to a level such as 80% of the initial underlying level. This means that they can pay a positive return in the case of rising and flat markets and those that fall but not beyond the defensive level. By covering so many market direction outcomes the correlation of the payoff to a long market position is much reduced and gives it strong market neutral credentials. It also has the advantage that it is achieved in a way that is arguably a lot simpler than the dispersion and range accrual constructions in particular.
The Bonus certificate is very similar and is popular in continental Europe and other markets. Typically this is a product with a fixed term and the bonus amount is paid if the underlying is above the barrier level which is set deep like the defensive Auto-call.
Conclusion: you don’t have to always bet on rising markets
Market neutral and absolute return funds continue to be a consideration for more sophisticated investors as part of their portfolios and strategies. In addition these concepts have wider application and these techniques have been adopted in structured products as discussed above. They include some interesting product ideas which offer alternative way to generate returns that are less dependent on continued strong market growth.
A version of this article has also appeared on www.structuredretailproducts.com
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