Market-Neutral Investing : Long/Short Hedge Fund Strategies

Joseph G. Nicholas

1 Not the best source for informatin
Nicholas runs a hedge fund consulting company and a lot of what he writes is not industry standard but rather what he thinks should be industry standard. There's a lot of different definitions in the HF industry on what long/short equity really means. Nicholas won't tell you what other authorities think. So this is a book with a very narrow focus, but even in this area it fails to clearly identify the risks of these equity hedge funds. You have to keep in mind that this guy is a promoter of the HF industry, so he's not an unbiased analyst of what hedge funds can do and cannot do. He's here to "sell" hedge funds... and to sell his company's services. I do not recommend this book because it's not objective at all.

2 Highly Recommend!
Market-Neutral Investing offers insightful strategies to the world of hedge funds. An industry leader, Joseph Nicholas pioneers us through his proven techniques. I highly recommend this book.

3 Very good primer on this investment style
Joseph Nicholas is uniquely positioned to write an intelligent book about market neutral investing. He is the founder of a hedge fund research firm that tracks over 2,500 hedge funds and has developed several hedge fund indexes. The language and mathematics within the book are crystal clear. Overall, this book gives you an excellent technical foundation in market neutral investing.

As Nicholas describes, the market neutral strategy encompasses eight different substrategies that deal with financial instruments ranging from equities, to convertible bonds, and mortgage backed securities. Nicholas dedicates a whole chapter for each substrategy. Within each chapter, he describes how a specific strategy structures its market neutral positions, how it earns its return, and what risks it bears.

Nicholas explains clearly that market neutral investing derives its return not from market movements, but from changes in the relationship or spread between its long positions and its short positions within a certain type of securities.

Market neutral investing consists in observing relationships between similar securities; and taking a long position in the ones that appear underpriced while taking a short position in similar securities that appear overpriced. This strategy is called convergence. The investor bets that the spread between the values of securities he is long and the one he is short will narrow. This entails that in relative term, the long positions are expected to appreciate and the short position are expected to depreciate. Thus, the values of the long undervalued positions and the values of the short overvalued positions should converge over time. That would be ideal. It does not always work out that way. Often, the long and short positions respective values do not converge, but diverge. That is what killed Long Term Capital Management.

The one caveat is that this book comes across as a commercial for market neutral investing. Nicholas convinces you will earn superior risk adjusted returns vs. regular investing strategies. Also, you will benefit from the market neutral strategies being uncorrelated to traditional stocks and bonds markets. Thus, market neutral strategies provide you with diversification benefits.

Regarding diversification benefits, Nicholas is correct. Given that these strategies returns are somewhat independent from market movements in the related securities, it makes sense that they would be uncorrelated to these same markets.

Nicholas assertion that these strategies provide superior risk adjusted return is less convincing. I would not be surprised his data is victim of survivor bias. If you select only the funds that survived during your research period, you ignore all the funds that failed during this same period. As a result, you overstate the performance of this investment style by selecting only the strong survivors. Additionally, his time horizon is too short. On page 7, he graphs the risk vs. returns for different market neutral strategies during the nineties alone. That is not long enough. Granted some of these strategies did not exist for much longer. Thus, we can't tell yet if performance is for real. Also, he states that all these strategies are above the efficient frontier that represents a straight line between the T-Bill risk/return position and the S&P 500 risk/return position. But, the efficient frontier is not on a straight line, but rather on a concave line. If the efficient frontier was graphed correctly, many of the market neutral strategies would be under the efficient frontier.

I am skeptical about the superior risk adjusted return of market neutral strategies because of my own experience. We invested in three such market neutral funds. They had alluring past performance that confirmed everything Nicholas says about such funds. The minute we invested in such funds, their performance mysteriously deteriorated. Somehow, all these funds benefited from convergence before we invested. But, suffered from divergence right after we invested. Within two years, we closed out our investment positions in all three funds, and never regretted it. Thus, I feel that data integrity, and disclosure are real issues in this industry. And, it undermines the credibility of their superior past performance.

My reservation regarding market neutral investing are supported by well publicized failures of some of the biggest funds within this investment style. These include the failure of Long Term Capital Management and the liquidation of the Tiger Funds.

If you want to track how a market neutral fund performs, you can follow one of the oldest AXA Barra market neutral fund (SSMNX). As you will see, the performance is lackluster. And, I believe it is representative of the performance of this sector.

Besides my reservation regarding market neutral investing, this book gives you an excellent foundation on this subject.

4 Good introduction, not too heavy
This book is up to date and starts off with a good overview. It then explains in a concise section what alpha and beta are, and also about efficient frontiers for different strategies (graphs of risk v return, showing what would happen if you were 100% strategy, 100% bonds, or a mixture of the two). It then goes into a detailed description for each strategy what the practical issues are.

5 not for professionals
if one is contemplating investing in hedge funds personally,pursuing a career in hedge funds,starting a new job in an institution which invests in hedge funds, or just curious, then this book may be helpful. it is NOT going to be additive to most investment professionals, i.e. if you are already doing it, this book will seem very very basic. I bought it in the hopes of picking up new perspectives on structuring a hedged portfolio. in hindsight, I should have given the money to a qualified charitable organization...

6 Best source for details
Great book. This is the best source for detailed descriptions of hedge fund styles and where their returns come from.

7 Excellent book, very informative yet extremely easy to read
While this book won't prepare you to start your own hedge fund or proprietary trading operation, it is a must read for anyone considering alternative investments. Mr. Nicholas gives the reader a concise and understandable treatment of most hedge fund strategies. Each strategy is covered in its own chapter, including multiple examples of the strategy in action; a simplified explanation of the mathematics the strategy depends upon, a history of the strategy and a comparison of the strategy's historical returns with those of other assets such as stocks, bonds and treasuries.

If you are a trader, fund manager or other financial professional you might find the material a bit basic, but your clients undoubtedly would benefit from your recommendation of this book. Even those with advanced finance degrees will likely find this book an excellent overview of the rapidly expanding opportunities in alternative investments.

8 For Beginners Only
In my view, this book contains no real information what so ever. It gives you a very shallow overview of different market neutral strategies. The information is directed toward beginners and do not provide any insight in how to value, execute or manage these strategies. I do not recommend it.

9 Highly Recommended!
Joseph G. Nicholas' thorough breakdown of market-neutral investing reveals some common threads and some striking differences between the most common strategies. Most of these strategies, some of which are based on newly developed financial instruments, are not available to average investors or even to many mutual fund managers. Instead, they serve as tools for money managers at the world's largest institutions. Nicholas uses mostly non-technical language and defines all important terms in a glossary, so that even a lay reader can understand. He also keeps math to a minimum. As a result, his book makes the seemingly dry realm of hedge fund investment techniques interesting and accessible while delving deeply into each strategy's approach to risk and reward. We [...] recommend this book to money managers, finance professionals and investors considering a hedge fund investment. But in light of the role that these strategies played in the collapse of former world-beater, Long-Term Capital Management, any student or professional would benefit from gaining at least a cursory notion of how they work - or don't work.

10 Very useful, but hardly groundbreaking
Is it possible to hedge the risk of a single investment? Of course. Is it possible to hedge market-wide risks? Yes, although not in quite such a straightforward manner. The authors of this book breathlessly report this same conclusion as if it were brand new, and not taught in finance courses around the country. Although the resulting precious tone is annoying, it does not detract from the value of the rest of the book, which is essentially a primer in market-neutral investment, and a good one.

Absolute Returns: The Risk and Opportunities of Hedge Fund Investing