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What is Market Neutral?

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  • Written By: Mary McMahon
  • Edited By: O. Wallace
  • Last Modified Date: 29 July 2018
  • Copyright Protected:
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    Conjecture Corporation
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Market neutral is a term used to refer to a portfolio of investments which are designed to generate consistent returns over time by avoiding a specific market risk or family of risks. While all investment portfolios are intended to generate returns in the long run, a market neutral portfolio usually touts returns at a steady rate, and returns which are not dependent on the fluctuations of the market. Actually creating a truly market neutral portfolio is extremely difficult, because there are so many variables involved.

Hedging is a commonly used technique to create a market neutral portfolio. Investments may be balanced between advantageous long term investments and more volatile but potentially highly profitable short term ones, and the market neutral portfolio is intended to generate returns whether the market is headed up or down. This can involve investing in various areas, focusing on particular types of investments, or diversifying investments in a way that reduces risk.

Running a market neutral portfolio can be risky. These portfolios tend to have less liquidity, which can put them in a vulnerable position, especially in the case of a fund, where investors may pull out and cause a ripple effect. It's also possible to take losses on the short term investments which cannot be made up. While the market neutral investments are supposed to have no correlation with fluctuations in the market, unpredictable things do happen, and a bad investment can occur. The risk of such events is known as basis risk.

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Funds based on a market neutral investment strategy usually boast of returns slightly above those on government securities. While government securities are very low risk, they also usually have low returns, which can make them unappealing. A market neutral investment plan also carries risk, but the greater possibility of return, making it appealing for some investors. It's important to evaluate potential investments carefully and to look up performance records on market neutral funds to decide whether or not they are worth the increased risks.

People who want to develop an investment strategy which follows this model can do so with the assistance of a broker, or on their own if they have sufficient experience. Other investors may choose to invest in funds, rather than trying to construct their own portfolios. As always, it is advisable to make investments diverse, and to avoid relying on a single fund or security to make a profit.

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