Diversifying Market Risk through Market-Neutral Strategies

Usually hedge funds are linked to concepts such selection and (subject to abnormal risks). Recent literature has pointed out that seldom hedge funds achieve performances significantly higher than broad capitalization market indices or mutual funds, and that basically hedge funds are just a different way to rule the agency relation between investors and the investment manager. From this consideration follows that one of the most important features of hedge funds is the manager's ability to take both long and short positions on the markets. Combining long and short positions in the same portfolio an hedge fund can rule out market risk and obtain a stream of returns uncorrelated to market returns. What I point out in this paper is that even without superior selection abilities by the hedge fund manager the uncorrelation of market neutral strategies with market returns can encourage mutual funds manager to invest a relevant portion of their portfolio in market neutral hedge funds. Simulating simple market neutral strategies on the European stock market from 1980 to 2001 I demonstrate that mixing these portfolios with traditional benchmark portfolios (the tipical mutual fund) fund manager can obtain significant risk reduction whitout the typical illiquidity costs that arise from investing in less developed markets, the ones where one can obtain similar low levels of correlation whith advanced countries stock markets.