INSIGHT
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To achieve uncorrelated returns in a highly correlated market, a market neutral strategy is required to completely eliminate market risk (beta) so returns are derived exclusively from stock selection (alpha). Market risk is eliminated through beta-neutrality, where the net-weighted average of the long and short portfolio betas equal zero. Beta-neutrality is the key differentiator between equity long-short and equity market-neutral strategies. Beta-neutrality eliminates market risk, and by doing so, generates returns that are independent from market movements.
Conventional wisdom is that risk and return are inherently linked. Greater returns necessitate bearing greater levels of risk. As a result, the only way to consistently outperform the market is to have a diversified portfolio with more systematic risk than that of the overall stock market. Microcaps defy such conventional wisdom, and provide returns far greater than their systematic risk dictates. Research shows that micro cap stocks provide annual returns in excess of those predicted by the Capital Asset Pricing Model (CAPM) by at least 5%, which is far more than that of larger companies. History has demonstrated that micro cap companies provide superior absolute and risk-adjusted returns versus larger market capitalizations; a trend likely to continue due to the inherent inefficiencies existing within the micro cap market. Simply put, micro cap portfolios have a higher probability of producing significant positive alpha.
Equity long-short hedge funds, also referred to as equity hedge strategies, have existed for decades and constitute the largest segment of the hedge fund industry. Popularity has been driven largely by the perceived ability both to preserve capital and to generate absolute returns - profits regardless of market conditions. The last decade put these return objectives to the test as equity markets had their worst decade in recent memory. From January 2000 to December 2009, the S&P 500‘s ten-year total return was -9.1%, and other markets didn’t fare much better. As we’ll see however, equity long-short strategies not only outperformed equity markets for the decade, but did so while incurring significantly less risk and volatility.