Market Neutral Strategies

Market neutral trading is one of the most popular classes of hedge fund strategy, often utilising CFDs and other derivatives to buy one stock and short another simultaneously, as well as using leverage.

Typically, a hedge fund may run a significant portfolio of long and short positions, maintaining a broadly market neutral approach, which is almost self-financing. Average holding time and turnover of stock will depend on the model or black box used by the fund, which is often based on historical statistical analysis of share prices. Longs and shorts may not be limited to one country, with a long position being established in, say, a German insurance company against a short position in a UK insurance company, while simultaneously hedging the currency risk. The strategy works particularly well where there is a good historic correlation between stocks, but a significantly wide enough arbitrage channel or stock volatility, to take advantage of short-term price discrepancies; or where there is plenty of volatility between stocks but not necessarily any market direction. It doesn’t work well when stocks are subject to company specific events like takeovers or corporate actions.

Pairs trading

In its simplest form a relative asset allocation play involves buying one stock and selling another; or maybe buying a stock and selling futures on an equity index against it to reduce directional market risk. Pairs trades such as this can be attractive to traders who prefer to run positions less sensitive to the general direction of the market.

If the two assets are quoted in different currencies, a currency transaction hedge is usually undertaken, which involves selling the currency where the short sale has generated a cash balance to fund the long position.

Pairs trade performance can be monitored in terms of the ratio between the two shares.

Example: Pairs trading, Land Securities vs British Land

Take the example of Land Securities trading at 1169p, and British Land trading at 685p. A chart of the two companies’ share price performance is shown below.

Figure 2.60: Land Securities and British Land – example of pairs trading

Used with permission from Bloomberg L.P.

Dividing one share price by the other to obtain a ratio is an effective way of monitoring the performance of the trade.

Figure 2.61: Land Securities and British Land ratio chart

Used with permission from Bloomberg L.P.

The ratio here is 1.707 (1169/685), and it can be seen that over the ten month period covered, the ratio ranged between 1.78 and 1.64 – around an 8% range. The ratio is currently right in the middle of this range but, as it drifts down towards 1.64, Land Securities is trading cheap against British Land, whereas at the top of the range, Land Securities starts to look expensive against British Land.

The sharp fall in Land Securities’ performance against British Land in late November, and subsequent recovery in early December, can be attributed to the sharp rise in British Land (partly as a result of a Morgan Stanley upgrade ahead of results), which was not reflected in the Land Securities price until early December.

Dividends should always be monitored for both stocks as this will distort the ratio, and may skew the apparent performance. Most CFD providers deduct 100% of the dividend for short positions, but only pay 90% for long positions, so there may be an additional loss of performance over the dividend date.

Most hedge funds will exclude stocks where a special situation exists or a corporate action is pending, and a great deal of research and analysis involving back-testing goes into identifying suitable stocks to trade.

Case study

30th January

• • Sell 4985 Land Securities @ 1003p
• • Buy 8636 British Land @ 579p

Trade established at a ratio of 1.73, value £50,000 per leg

12th February

• • Buy 4985 Land Securities @ 1045
• • Sell 8636 British Land @ 622p

Trade closed with a ratio of 1.68

P/L

• • Loss on Land Securities: 4985 * 42p = £2,094
• • Profit on British Land: 8636 * 43p = £3,713
• • Overall profit: £1,619

Although both stocks have moved up during the period, British Land has outperformed Land Securities, so the loss on buying back Land Securities has been outweighed by the higher profit on the British Land leg. Throughout the trade, the trader can easily monitor the performance of the trade by monitoring the ratio. So if Land Securities is trading at 1030p and British Land at 609p, the current ratio is 1.69, and the trade is around 2.4% in profit. Since the position was established with a value of £50,000 each leg, the profit as of that moment will be approximately 2.4% on £50,000 = £1,200.

Similarly, the P/L at any one time will be the difference between the current size of the long position and the short position:

Size of short position: -£4,985 * £1,030 = -£51,346

Size of long position: £8,636 * £609 = £52,593

Profit & loss: -£51,346 + £52,593 = £1,247

Pairs trading Schroders shares

One of the most popular spread trades in the UK is the arbitrage between the two classes of Schroders share: the ordinaries and the non-voting shares. As can be seen from the chart below, the ordinary shares have traded at a premium to the non-voting shares of between 9% and 15% over the nine-month period selected from September 2003 to May 2004.

Here a trader might sell the ordinaries and buy the non-voting shares when the discount gets to the top of the range, around 14%. Trades are often put on in incremental percentages (13%, 14%, 15%, 16%, etc.) to allow some flexibility in unwinding the position on reversal. Establishing the position in reverse, i.e. shorting the cheaper share and buying the more expensive when the premium nears the bottom of its range, is often referred to as chinesing the spread.

Liquidity in the non-voting shares can be limited, and therefore it can be difficult to establish a reasonable size position. This is not a trade where the trader will get rich quickly and, as the potential return is limited, it will only be suited to traders who have direct market access and low execution costs. Nevertheless, it is an excellent situation on which traders can cut their teeth, learn the nuances of direct market access, manage contingent orders and appreciate the importance of liquidity matching.

Figure 2.62: Schroders (SDR) – historical premium of voting shares over non-voting shares

Used with permission from Bloomberg L.P.

It is an unfortunate characteristic of pairs trading that the further the divergence between the two stocks, the more attractive the trade becomes. It can be good discipline to establish a pairs trade at certain incremental levels to allow some flexibility in unwinding the trade. However, there has to be a point at which defeat must be acknowledged when an historically correlated pair breaks down.

The strategy is very capital intensive and sensitive to cost, as one pairs trade involves four transactions to both establish and unwind the position. The lower the difference in funding costs between what is paid on long positions and what is received on short positions, the closer the position will be to self-financing. Regular traders should seek margin relief from their CFD provider.

Use of ratio charts

Using ratios and ratio charts is an extremely effective way of identifying and monitoring pairs trades. In contrast, charts which track relative performance are usually normalised at some random point in the past. A ratio chart gives the trader an instant feel for the volatility within the ratio, the arbitrage channel and whether the ratio is trending one way or another. Ideally a ratio chart should trend sideways with no measurable outperformance of one stock over another but enough variation in the share price differential to be able to trade. It can also be important to look at longer time frames as well as shorter ones. An ideal pairs trade ratio might resemble a mathematical sine wave; with no out performance of one stock over the other in the long-term, but sufficient amplitude to generate an arbitrage channel.

Other popular pairs trades in the UK include:

• • HSBC-Standard Chartered
• • Aviva-Prudential
• • BATS-Imperial Tobacco
• • Unilever-Reckitt Benckiser
• • BP-Shell
• • Reed-Pearson

Regression charts can also be used to monitor the current relative positions of the two stocks and identify opportunities, and are a key component is assessing past performance.

Figure 2.63: Regression chart for pairs trading

Used with permission from Bloomberg L.P.

Balance sheet arbitrage

When one quoted company holds a significant stake in another, there can be a loose arbitrage opportunity if the valuation of one dramatically exceeds the other.

Examples in the UK are rare, but during 2000 and 2001, Dixons’ stake in Freeserve far exceeded its own market value. These discrepancies can last for some time, and there can be other issues such as tax considerations and the debt held in one of the entities.

In Europe there are several examples of companies that trade at a variable discount to their quoted constituent parts. The opportunity can come in trading the channel that this discount ranges in, by buying the holding company and short selling the constituent assets as a simultaneous basket trade hedge in the appropriate ratios. The trade is then unwound when the discount narrows, and even chinesed by shorting the holding company and buying the underlying assets, if the discount narrows to such an extent that it may be expected to widen again.

Popular European holding company trades against the corresponding constituents include:

• • Investor (Sweden);
• • Dior (France); and
• • Heineken.

Investment trust discounts

Similar opportunities can present themselves by trading investment trust discounts.

When the trust trades at a wide discount to its constituents, the trust’s shares are bought and the constituents, or proxy hedge, are sold. When the discount narrows the trade is unwound. Similarly, if the trust trades at a premium, or the discount is expected to widen, the investment trust shares can be shorted (if borrowable), and the constituents bought as a basket.

Convertible bond arbitrage

As explained previously, if all variables for an option are known, including the price, the one remaining variable, the (implied) volatility, for that option can be calculated. This can then be compared with the historic statistical volatility of the underlying instrument. If the implied is lower, it suggests the option is cheap, or if the implied is higher, it suggests the option is expensive.

Convertible bonds and callable bonds can be regarded as comprising:

1. • a fixed interest element; together with
2. • an option to convert into the underlying.

The option part will have a value that can be calculated by taking the price of the convertible bond and stripping out the fixed interest component (which will be priced according to the company’s credit rating).

Callable bonds are repackaged bonds issued by investment banks, generally yielding more than the underlying, with an embedded option giving the issuer the right of repurchase if triggered by certain events.

Isolating volatility

Traders can isolate volatility embedded in a convertible by shorting the stock and delta hedging against a long convertible bond position. However, if the volatility of the stock turns out to be lower than anticipated, the convertible bond trader who is long of premium will lose out.

Convertible bonds are usually initially sold with the implied volatility priced at a discount to the historical volatility of the stock in order to make them attractive. Convertible bond issues are particularly attractive with hedge funds that will look to extract the volatility embedded in them. They will buy the convertible and hedge the position by short-selling stock against it in the appropriate ratio. This is why a stock can sometimes be hard to borrow and experience some weakness in its share price, at the time of issue of a convertible. The investment bank will frequently package together the convertible and borrowing facility in the stock before offering it to hedge funds and proprietary traders.

It should also be remembered that the fact that the company has issued a convertible bond in itself might alter the volatility of the stock, depressing it more than anticipated. This is because as the stock rises, the hedgers will sell stock and as the stock falls they will buy it, improving liquidity and dampening volatility. The lesson, therefore, is to expect share price weakness when a convertible bond is issued.

If the convertible trades expensive, the trade can chinese the spread by shorting the bond and buying the underlying stock in the cash market at the appropriate ratio.

Example: United Business Media

United Business Media launched a $400m offering of five-year convertible bonds due in 2006 with a conversion price of 577p and interest rate of 2.375% on 14 December 2001.

Figure 2.64: United Business Media (UBM) – convertible issue

Used with permission from Bloomberg L.P.

Dual listed shares and cross border arbitrage

A number of companies have dual listed shares. In other words, the stock is quoted in different jurisdictions and in different currencies. These are generally not fungible (deliverable against each other), so a strict arbitrage does not exist, and although the prices will be closely aligned they will fluctuate with local supply and demand.

The best known and well established of these is the dual listed Anglo-Dutch shares of Royal Dutch Shell, Unilever and Reed Elsevier.

Royal Dutch/Shell arbitrage

For years the Royal Dutch shares listed in Holland traded at a premium to its counterpart Shell shares in the UK, partly due to different taxation rules regarding dividends, and Royal Dutch being a member of the main US indices; this premium has ranged as wide as 20%. The strategy of buying one and short selling the other, as well as transacting the currency hedge, thereby makes the trade circular, is capital intensive, and its one of those pairs transactions that unfortunately get more attractive the wider out they get.

Neither are they risk free, as the Long-Term Capital Management (LTCM) hedge fund found out in 1998 when it bought Shell and sold Royal Dutch short in huge numbers, as the spread continued to widen. This was just one of a number of trades that theoretically have a low risk, but, when the sixteen banks that had extended margin credit to LTCM decided that they wanted their money back, LTCM ended up having to be rescued to avoid a crisis in the entire financial industry.

This scenario is often associated with noise trade risk, where the unpredictability of noise trader’s beliefs deters arbitrageurs from trading against them. In other words, the fact that the mispricing exists can cause it to increase.

Some arbitrages, however, exist purely because the cost of the arbitrage is prohibitive. That’s to say, the high cost of borrowing the overpriced asset to short sell is reflected in the spread itself.

Other dual listed shares where there is an arbitrage opportunity are listed in the table below.

Table 2.13: Dual listing arbitrage opportunities

Domestic	Foreign
Billiton (UK)	BHP (AU)
Brambles (UK)	Brambles Industries (AU)
Carnival (UK)	Carnival (US)
Corus (UK)	Corus (NL)
Rio Tinto (UK)	Rio Tinto (AU)

Brambles has been dual listed in the UK and Australia since June 2001, although the Australian quote has historically traded at a premium, as illustrated below.

Figure 2.65: Brambles (BI) – percentage premium of Australian quote over UK

Used with permission from Bloomberg L.P.

It is frightening how many novice UK traders are unaware of closing prices quoted in other jurisdictions in stocks that they trade. The percentage move on the day is irrelevant, especially if the two markets overlap trading hours (like the US and UK). What matters is the closing price adjusted for the currency – which can of course itself move overnight.

If you are trading a stock, it is essential that you are aware if it has a dual listed quotation (and what the closing price of the other share is when converted from the local currency), so you are not caught out by an unexpected overnight move in the other market.

UK quoted companies with active quotations in South Africa include: Anglo American; BHP Billiton; Investec; Liberty International; Old Mutual; Randgold Resources; and SAB Miller. If you are trading these stocks without access to live prices for the other markets you may as well be driving blind.

Stocks like Bookham, where the number of shares traded on NASDAQ in the US exceeds the number of domestic shares traded in the UK by over 50%, are effectively driven by the US quote. One reason why Bookham sought to cancel its UK listing and move to the US, was that it felt technology stocks were better understood in the US, with higher representations in the benchmark indices.