Are Market Neutral Hedge Funds Really Market Neutral?
Sep 20th, 2006 | Filed under: CAPM / Alpha TheoryBy: Andrew Patton, London School of Economics
Published: October 5, 2005
Various academics such as Luis Seco of the University of Toronto have argued that hedge fund market correlations (and cross-correlations) move closer to 1.0 in times of distress. So the question of the “true” neutrality of hedge funds is important – especially when trying to short-out market exposures. In this paper, Andrew Patton of the London School of Economics proposes several new measures of market neutrality to help us get a better understanding of “market neutral”.
“We propose five new neutrality concepts for hedge funds: mean neutrality, which nests the standard correlation-based definition of neutrality; variance neutrality, Value-at-Risk neutrality, and tail neutrality, which examine the neutrality of the risk of a fund to market risk; and complete neutrality which corresponds to independence of the fund and the market returns.”
Patton draws a direct link between his research and portable alpha investing:
“The low correlation of hedge fund returns is related to the development of so-called portable alpha strategies…The methods proposed in this paper may be interpreted as tests of the purity of the portable alpha strategy: if some dependence on the market risk is detected, then this would need to be accounted for when incorporating the hedge fund investment in a portfolio with other exposures to market risk.”
The paper concludes that “market neutral” hedge funds may not all be entirley “market neutral” according to tests of statistical significance:
“In summary, we conclude that between 20% and 30% of market neutral funds in our sample exhibit [statistically] significant deviations from market neutrality.”
But, Patton goes on to explain that such a rigorous mathematical test may be overkill…
“Declaring a fund to be non-neutral if it fails at least one test for market neutrality leads to a size distortion. For example, the probability that a truly market neutral fund fails at least one of five independent tests of market neutrality, each with size 0.05, is 0.23.”
…And that ”market neutral” hedge funds were, all in all, actually quite market neutral compared to other hedge fund strategies:
We compared the results for the market neutral style with those obtained by looking at equity hedge, equity non-hedge, event driven and fund of fund hedge funds, and found strong evidence that market neutral funds are more neutral to market risks than these funds.”…our findings suggest that many market neutral hedge funds are in fact not market neutral, but overall they are, at least, more market neutral than other categories of hedge funds.”
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[...] Research from Yale University and the London School of Economics backs him up on this.  [...]