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Market-Neutral: A Case for a New Strategy
Alpha Theory's analysis reveals that market-neutral strategies using optimal sizing significantly outperform traditional sizing, achieving 12.1% returns and a Sharpe of 1.89x with no down years. With growing investor interest in market-neutral portfolios, this approach offers compelling risk-adjusted returns and a promising path forward for equity managers.
In our previous analysis of the Alpha Theory Stock Selection Index, we showed how our clients excel at picking stocks by creating an equal-weighted 100 L by 100 S portfolio that generated 8% returns, 5% vol, and 1.5x Sharpe. Impressive!
We wanted to expand the analysis by creating the same 100 x 100 portfolio but using the manager’s actual position sizes and Alpha Theory Optimal. Basically, a market-neutral version of our clients.
Looking at the data from 2012 through early 2024, manager selection and sizing combined into a market-neutral strategy generates compelling returns of 6.2% and a Sharpe of 1.14x with only 2 down years.
But there is a much better version of their portfolios using their Alpha Theory Optimal sizing. Returns have almost doubled to 12.1% with only slightly higher volatility, resulting in a Sharpe of 1.89x and 0 down years. Ten of thirteen years show managers’ actual sizing underperforming their Alpha Theory Optimal.
Looking Forward – A Case for Market-Neutral Returns
For active equity managers, inflows are largely being directed towards market-neutral strategies. The reasons are two-fold. Market-neutral produces nice risk-adjusted returns and they eliminate investors paying for the beta inherent in net long portfolios.
Looking at the analysis presented here, many of Alpha Theory’s long-biased portfolio managers could create market-neutral portfolios that would both meet the market demand and provide compelling risk-adjusted returns. This may be the next chapter for our managers, and we look forward to working with them to build these business-transforming strategies.
