Equity Market-Neutral

Strategy
When effectively managed, an equity market-neutral
strategy should generate returns in excess of cash,
while being largely independent of the market’s
performance.

What is Equity Market-Neutral?

Equity market-neutral hedge funds buy stocks (go long) and sell stocks
(go short) with the goal of neutralizing exposure to the general stock
market and capturing a positive return, regardless of the market’s
direction. Equity market-neutral is a term that includes different equity
strategies with varying degrees of volatility, and an emphasis on
maintaining neutrality to the equity markets. When effectively
managed, an equity market-neutral strategy should generate returns in
excess of cash (i.e., T-bills or LIBOR), while being largely independent
JUNE 2006 NUMBER 1 of the market’s performance. Thus, the returns captured from the stock
selection process should be the value added by the manager.

An equity market-neutral strategy seeks to generate returns by

exploiting equity market inefficiencies, and involves simultaneously
holding long and short equity portfolios of approximately the same
dollar amount.1 Trades involve buying attractive stocks, the long
portion of the portfolio, and selling unattractive stocks, the short
portion of the portfolio. The spread between the performance of the
longs and the shorts, and the interest earned from the short rebate,
provides the primary return for this strategy. Equity market-neutral may
be viewed as a natural extension of long-only equity management, as it
typically focuses on the fundamental factors associated with stock
picking.

The variety of global equity markets and sectors creates many possible
permutations and combinations of universes for equity market-neutral
managers to explore. Also, since data for equities in developed markets
are readily available, managers can use advanced mathematical
algorithms and rigorously back-test models.

Note on Key Terms: There is a “Glossary of Key Terms” at the end of the strategy paper on
Page 10. The key terms are italicized and underlined in the text.

1AIMA Canada’s paper An Overview of Short Stock Selling summarizes the mechanics of selling
stocks short. Also, refer to AIMA Canada’s paper Long/Short Equity Strategy for a detailed
discussion of this strategy.
 JUNE 2006 NUMBER 1

What are the Nuts and Bolts of Equity science. The portfolio construction phase should
Market-Neutral? dovetail with risk management issues, such as
maximum exposure to any single security or sector,
An equity market-neutral strategy usually involves and the appropriate amount of leverage to be
simultaneously holding matched long and short stock employed.2
positions to take advantage of relatively under-priced and
over-priced stocks. The strategy strives to provide What are the Different Approaches to
positive returns in both bull and bear markets by Equity Market-Neutral?
selecting a large number of long and short positions with
There are two basic approaches to equity market-neutral:
no net exposure to the market. An equity market-neutral
statistical arbitrage and fundamental arbitrage. Many
strategy can be established in terms of neutrality based
successful managers blend the two techniques,
on the following factors: dollar amount, beta, country,
depending on market conditions and/or their expertise.3
currency, industry or sector, market capitalization, style
(value/growth), and other factors or a combination Statistical Arbitrage
thereof. Statistical arbitrage involves model-based, short-term
trading using quantitative and technical analysis to detect
There are three basic steps in an equity market-neutral profit opportunities. Normally, a particular type of
strategy: arbitrage opportunity is hypothesized, formalized into a
set of trading rules and back-tested with historical data.
1. Select the Universe: The universe consists of all In this manner, the manager hopes to discover a
equity securities that are candidates for the portfolio persistent and statistically significant method to detect
in one or more industry sectors, spanning one or profit opportunities. Critics refer to this strategy as
more stock exchanges. Selecting a universe must be “black box” investing, given its lack of process
consistent with the manager’s core competencies. transparency.
For example, if the manager has extensive
experience in the energy sector, then a large portion Below are three typical statistical arbitrage techniques:
of the universe would likely be energy stocks. The
stocks in the universe should have sufficient 1. Pairs or “Peer Group” Trading: Involves
liquidity so that entering and exiting positions can be simultaneously buying and selling short stocks of
done quickly, and it should be feasible to sell stocks companies in the same economic sector or peer
short (i.e., must be possible to short the stock and group, as defined by the manager. Typical
the stock borrowing cost must be reasonable). correlations are measured and positions are
established when current prices fall outside of a
2. Generate a Forecast: Equity market-neutral hedge
funds typically have a proprietary trading model that
generates potential trades. The algorithms should
indicate each trade’s expected return and risk, and 2 In an equity market-neutral portfolio, the gross market exposure is typically

implementation costs should be included when 200% (i.e., $1 long exposure + $1 short exposure = $2 of exposure), while the
net exposure is zero. This portfolio is deemed to use no leverage. However, if
determining the net risk-return profile. the portfolio has gross market exposure of 300% (i.e., $1.50 long + $1.50
short), leverage is employed. AIMA Canada’s paper An Overview of Leverage
3. Construct the Portfolio: In the portfolio summarizes the key definitions and types of leverage used in the different
hedge fund strategies.
construction process, the manager assigns weights
(both positive and negative) to each security in the 3The basic approaches here focus on technical vs. fundamental, although
approaches may differ. For example, some managers focus on factor neutrality
universe. There are different portfolio construction and try to predict stock price reversion to the mean (statistical arbitrage), while
techniques, which are typically a blend of art and other managers focus on exploiting predictability of factors (equity market-
neutral). Both of these approaches may be done technically or fundamentally.

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normal band. Position sizes can be weighted to arbitrage as the number of stocks is generally fewer than
achieve dollar, beta or volatility neutrality. Positions in statistical arbitrage.
are closed when prices revert to the normal range or
when stop losses are breached. Portfolios of multiple What are the Sources of Return of Equity
pair trades are blended to reduce stock specific risk. Market-Neutral?
2. Stub Trading: Involves simultaneously buying and Equity market-neutral managers use their skill and
selling short stocks of a parent company and its experience to detect equity market inefficiencies, in
subsidiary(ies), depending on short-term direct opposition to the efficient market hypothesis. The
discrepancies in market valuation versus actual stock basic assumption is that anomalies in relative stock
ownership. Position sizes are typically weighted by valuation occur in the short term, and that these
percentage ownership. anomalies correct themselves in the long term. Since an
equity market-neutral strategy often uses complex
3. Multi-class Trading: Involves simultaneously models to detect pricing inefficiencies, it may earn a
buying and selling short different classes of stocks “complexity” premium. Good models earn consistent
of the same company, typically voting and non- returns, provided others in the market cannot replicate
them.
voting or multi-voting and single-voting share
classes. Much like pairs trading, typical correlations
The following factors contribute to the different sources
are measured and positions are established when
of return for an equity market-neutral strategy:
current prices fall outside of a normal band.
1. No Index Constraint: Equity market-neutral
The leverage used for statistical arbitrage tends to be removes the index constraints that limit buy-and-
higher than for fundamental arbitrage, and typically hold market participants. Selling a stock short is
depends on the number of positions in the portfolio, the different from not owning a stock in the index, since
desired liquidity and the risk budget. the weight of the short position is limited only by the
manager’s forecast accuracy, confidence and ability
Fundamental Arbitrage to offset market risk with long position(s).
Fundamental arbitrage consists mainly of building
portfolios in certain industries by buying the strongest 2. Inefficiencies in Short Selling: Significant
companies and selling short companies showing signs of inefficiencies are available in selling stocks short.
Despite the phenomenal growth of hedge funds, the
weakness. The analysis is mainly fundamental and is less
total stocks sold short on the Toronto Stock
quantitative than statistical arbitrage. However, some
Exchange (TSX) remains at 1-2 days trading and
managers use technical and price momentum indicators
1.25% of market capitalization.4
(e.g., moving averages, relative strength and trading
volumes) to help them in their decision making. 3. Time Arbitrage: Equity market-neutral involves a
time arbitrage for short-term traders at the expense
Fundamental factors used in the analysis include of long-term investors. With higher turnover and
valuation ratios (e.g., price/earnings, price/cash flow, more frequent signals, the equity market-neutral
price/earnings before interest and tax [EBIT], manager can often profit at the expense of the long-
price/book), discounted cash flows, return on equity, term equity investor.
operating margins and other indicators. Portfolio
turnover is generally lower than in statistical arbitrage as
the signals are stronger but change less frequently. As
stated, more modest leverage is used in fundamental 4 Source: Toronto Stock Exchange (December 2005).

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4. Additional Active Return Potential: Equity reducing and/or customizing volatility. Reducing
market-neutral involves double the market exposure volatility allows for leverage to be used, which is a
by being both long and short stocks. At a minimum, source of return.
two dollars are at work for every one dollar of
invested capital ($1 long + $1 short = gross market 6. Profit Potential in All Market Conditions: By
exposure of $2 [or 200%], with net market exposure managing a relatively “fixed-volatility” portfolio, an
close to zero). Therefore, an equity market-neutral equity market-neutral manager may have an
manager has the potential to generate more than the advantage over a long-only equity manager. One
active return of a long-only equity manager. could argue that a long-only equity manager is
primarily a risk taker, subject to the vagaries of
5. Managing Volatility: Through an integrated equity market volatility and returns, while an equity
optimization, the co-relationship between all stocks market-neutral manager is primarily a risk manager
in an index can be exploited. Depending on the with flexible models, and can stay fully invested in
dispersion of stock returns (high being better), risk all market conditions.
can be significantly reduced by systematically re-
weighting positions to profit from offsetting Figure 1 highlights the typical sources of return for an
volatility (i.e., the portfolio volatility can be equity market-neutral strategy, which are derived from
customized and managed within a risk budget, given the above factors. (The sources of return in Figure 1 can
the volatility of long stocks and short stocks, and be cross-referenced with the respective explanations on
their respective co-variances.). Therefore, an equity Page 5.)
market-neutral manager can add significant value by

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Notes to Figure 1: Example of Equity Market-Neutral Return Attribution (No Leverage Used)

Note: The return attribution for an equity market-neutral portfolio has been simplified to highlight the key concepts. We
assume the portfolio is $1 long and $1 short, and that the market return is 10%. Note that no leverage has been used in the
example. The volatility of this type of equity market-neutral portfolio is typically lower than that of a long-only equity
portfolio.

Returns Generated on Long Positions + Short Positions: Capital gains/losses either realized or unrealized generated on
long and short positions in various equity securities.

+ Dividend Income (on Long Positions): Dividend income earned on long equity positions.

+ Interest Earned on Cash: If a manager has low gross market exposure, interest is earned on excess cash balances (e.g.,
long exposure of $0.80 and short exposure of $0.80 results in net market exposure of zero, gross market exposure of $1.60,
and a cash balance of $0.20).

+ Short Interest Rebate: A short stock sale is typically executed with the following steps: borrow shares, sell shares short,
receive cash in return for stock sale, earn interest on cash proceeds from short sale (i.e., the short interest rebate), buy back
shares, and return shares to stock lender. The rebate varies depending on prevailing market interest rates (i.e., typically the
broker “call rate,” which is the prime rate minus 50-75 bps).

- Cost of Borrowing Shares: When a short stock sale is executed, the equity market-neutral fund must borrow shares to
facilitate the transaction. The fund typically pays the stock lender a nominal rate based on the total value of the shares
borrowed and the period of the stock loan. The available supply of a particular stock impacts the borrowing cost with
tightly held, illiquid stocks often commanding a premium borrow rate.

- Dividend Payment (on Short Positions): When an equity market-neutral fund holds a short position in a dividend-
paying stock, that fund must pay the stock lender the value of any dividends that would have been received on the shares.

- Cost of Leverage (Margin Loans): If the manager uses leverage (through margin loans) to increase long positions
beyond $1, the fund must pay interest on the loan to its prime broker.5 (Note: 1-3 times leverage may be applied to the
entire position, depending on the desired volatility. Therefore, the total return will depend on the amount and cost of
leverage employed. The general cost of margin loans often differs by jurisdiction.)

= Total Return (i.e., Gross Return Before Fees)

5 AIMA Canada’s paper The Role of a Prime Broker provides an overview of the general prime brokerage functions.

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What are the Key Risk Factors of Equity effectiveness of the model may diminish as the
Market-Neutral? market environment changes.

The key risk factors of an equity market-neutral strategy 5. Changes in Volatility: The total volatility of an
are as follows: equity market-neutral position depends on the
volatility of each position. Therefore, the equity
1. Unintended Beta Mismatch: Long and short equity market-neutral manager must carefully assess the
portfolios can easily be dollar neutral, but not beta volatility of each long and short position and the
neutral. Reaction to large market movements is relationship between them, and also assess the trade
therefore unpredictable, as one side of the portfolio in the context of the total portfolio.
will behave differently than the other.
6. Low Interest Rates: Part of the return from an
2. Unintended Factor Mismatch: Long and short equity market-neutral strategy is the interest earned
equity portfolios can be both dollar neutral and beta on the proceeds from a short sale (i.e., the short
neutral, but severely mismatched on other important interest rebate). Thus, a lower interest rate
factors (e.g., liquidity, turnover, value/growth, environment places more pressure on the other
market capitalization). Again, large market moves return sources of this strategy.6
will affect one side of the portfolio differently from
the other. Risk management tools can assist the 7. Higher Borrowing Costs for Stock Lending:
manager in controlling factor mismatches. Higher borrowing costs cause friction on the short
stock side and decreases the number of equity
3. Leverage: Extended periods of low volatility or market-neutral opportunities available.
positive returns may encourage the manager to use
leverage in excess of the strategy’s risk parameters. 8. Short Squeeze: A sudden increase in the price of a
Position sizes greater than 5% of capital, low stock that is heavily shorted, will cause short sellers
turnover, and/or lack of a risk management to scramble to cover their positions resulting in a
framework all have the potential for large negative further increase in price.
drawdowns. However, using leverage by itself is not
a risk factor. Most equity market-neutral portfolios 9. Counterparty Risk: As with any hedge fund
have gross market exposure of 200%, although large strategy, high quality global service providers are
global market-neutral portfolios spread across essential. For an equity market-neutral strategy, an
hundreds of positions may use leverage with gross effective prime broker well suited to the manager’s
market exposure of 300-400% (i.e., $1.5-$2 long + particular market helps to ensure sound trade
$1.50-$2 short). execution and secure stock loans. Using a large and
well-capitalized prime broker assists an equity
4. Model Risk: All risk exposures of the model (within market-neutral manager in minimizing counterparty
reason) must be assessed to prevent bad forecast risk.
generation. Also, practical implementation issues
should be considered. For example, even if the
model indicates that a certain stock should be
shorted at a particular instant in time, this may not 6The equity market-neutral investor should always assess returns relative to T-
be feasible due to the “uptick rule.” Finally, the bills; however, higher or lower rates should not affect the manager’s active risk
and return.

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10. Currency Risk: Buying and selling stocks in been better than both equities and bonds. Some analysts
multiple countries may create currency risk for an argue that an equity market-neutral strategy has had
equity market-neutral fund.7 The cost of hedging, or superior risk-adjusted performance relative to other
not hedging, can significantly affect the fund’s hedge fund strategies, and also exhibits the “best-
return. behaved” return distribution by being closest to a normal
distribution.8
11. Lack of Rebalancing Risk: Finally, the success of
Of the statistics in Table 1, only two, the Sharpe Ratio
an equity market-neutral fund is contingent on
and the Omega Ratio reflect information about both
constantly rebalancing the portfolio to reflect current return and risk. The Omega Ratio is similar to the Sharpe
market conditions. Failure to rebalance the portfolio Ratio in that it is a ranking function (higher being better),
is a primary risk of the strategy. but it does not penalize for upside volatility, and also
captures all moments of the distribution including skew
What is the Historical Performance of and kurtosis. In simple terms, the Sharpe Ratio is the
Equity Market-Neutral? excess return per unit of volatility and the Omega Ratio
is a ranking of different investment returns at, or above a
Table 1 highlights that for the period January 1990 to desired threshold level (in this case 0.4% monthly). With
December 2005, equity market-neutral hedge funds a normal distribution, the Omega and Sharpe Ratios are
enjoyed returns similar to equities with volatility similar equivalent at the risk-free rate. The values for both the
to bonds. One could argue that on a risk-adjusted basis Sharpe and Omega Ratios in Table 1, highlight that an
(using standard deviation as a measure of risk), the equity market-neutral strategy (i.e., both fundamental
performance of equity market-neutral hedge funds has arbitrage and statistical arbitrage) exhibit superior risk-
adjusted returns relative to U.S. stock and bond indices.

Table 1: Equity Market-neutral (EMN) Performance Comparison (in US$) (Jan-1990 to Dec-2005)
HFR EMN HFR EMN Index S&P 500 Lehman
Key Statistics Index (Statistical Index Aggregate
(Fundamental) Arbitrage) Bond Index
Annualized Compound Return 9.1% 8.6% 10.5% 7.4%
Annualized Standard Deviation 3.1% 3.9% 14.4% 3.9%
Maximum Drawdown -2.7% -5.4% -44.7% -5.1%
1-month Maximum Gain 3.6% 4.5% 11.4% 3.9%
1-month Maximum Loss -1.7% -2.7% -14.5% -3.4%
Annualized Sharpe Ratio 1.5 1.1 0.5 0.8
Omega Ratio at 0.4% Monthly Threshold 2.9 2.0 1.4 1.6
Source: Hedge Fund Research Inc. (HFRI); Note that all hedge fund returns are net of all fees.
Note: Sharpe Ratio uses the 91-day U.S. T-bill rate for the period.

7 In certain situations, currency risk can be minimized. For example, if an equity

market-neutral portfolio is in C$, and the manager buys and sells U.S. stocks,
8 Refer to An Approach to the Non-normal Behavior of Hedge Fund Indices
the short sale proceeds in US$ will generally finance the purchase of the long
positions in US$, so currency risk may be minimal. Some US$ may be needed using Johnson Distributions, Pedro Perez (September 2004) presented to
for margin, but C$ collateral could be posted. The only currency risk in this Finance Department, ESSEC in Paris and submitted for publication.
situation would be the portfolio’s profit/loss.

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What is a Practical Example of Equity Market-Neutral?

Table 2: Example of Equity Market-neutral Trade (No Leverage Used)

Background to the Trade: The trade involves a long position of $1,000,000 in Mining Co. A with a beta of 1.2, and a short position of
$1,200,000 in Mining Co. B with a beta of 1, assuming $1,000,000 of capital. Both Mining Co. A’s and B’s dividend yield is 1%. The
trade is designed to be “beta-neutral.” The manager holds the positions for 1 year, where Mining Co. A’s stock rises by 30% resulting in
a gain of $300,000, and Mining Co. B’s stock rises by 12.5% resulting in a loss of $150,000. It is assumed that margin costs are 3% p.a.

I. Determining Total Return

Return Source Cost Exit Return ($) Assumptions/Notes
Base Proceeds
Long Position: Mining Co. A $1,000,000 $1,300,000 $300,000 50,000 shares purchased @ $20/sh.; Beta = 1.2
Short Position: Mining Co. B ($1,200,000) ($1,350,000) ($150,000) 80,000 shares shorted @ $15/sh.; Beta = 1
Dividend Income (on Long Position) $10,000 Dividend yield of 1% on Mining Co. A
Interest Earned on Cash $0 No excess cash
Rate of 1.5% earned on short proceeds of
Short Rebate (on Short Position) $18,000 $1,200,000
Rate of 0.3% paid on initial stock loan, with a
Cost of Borrowing Shares ($3,600) borrow value of $1,200,000
Dividend Payment (on Short
Position) ($12,000) Dividend yield of 1% on Mining Co. B
$1,000,000 Capital;
Long Cost = ($1,000,000);
Short Cost = Margin of $360,000 @3%, which is
calculated as follows:
= ($1,560,000)9 + $1,200,000 proceeds =
Margin Costs (on Short Position) ($10,800) ($360,000);
Net margin used = ($1,000,000) + ($360,000) +
$1,000,000 in capital = ($360,000) in margin @
3% rate
Note on Leverage: No leverage has been
employed in this trade.
Total Return $151,600

% Return 15.2% $151,600/Initial capital of $1,000,000

9 $1,200,000 X 130% short margin = $1,560,000

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II. Assessing Net Exposure

Details At Trade At Trade Notes
Inception Exit
Long Exposure 100.00% 130.0% Note on Beta-adjusted Net Exposure:10
Short Exposure -120.00% -135.00% ƒ Trade Inception: (Long exposure of 100% X beta of 1.2) +
Net Exposure -20.00% -5.00% (short exposure of 120.00% X beta of 1) = (120% - 120%) = 0%
Gross Exposure 220.00% 265.00% ƒ Trade Exit: (Long exposure of 130% X beta of 1.2) + (short
Beta-adjusted Net Exposure 0% 21% exposure of 135% X beta of 1) = (156% - 135%) = 21%

III. Analyzing Return Sources

Return Source Contribution
Long Position: Mining Co. A 30.0%
Short Position: Mining Co. B -15.0%
Dividend Income (on Long) 1.0%
Interest Earned on Cash 0.0%
Short Rebate 1.8%
Cost of Borrowing Shares -0.3%
Dividend Payment (on Short) -1.2%
Margin Costs (on Short) -1.1%
Total Return 15.2%

Conclusion
Equity market-neutral managers recognize that the markets are dynamic and take advantage of sophisticated mathematical
techniques to explore new opportunities and improve their methodology. The fact that there are many different investment
universes globally makes this strategy less susceptible to alpha decay. The abundance of data lends itself well to rigorous
back testing and the development of new algorithms. While advanced techniques may be used to generate an “edge,” the
underlying strategy typically focuses on fundamental factors associated with stock picking. Also, the liquidity of the
underlying stocks, the valuation of the portfolio and the transparency of the strategy, are all strengths of an equity market-
neutral strategy.

Written by Chris Guthrie, CFA, President, Hillsdale Investment Management Inc.11

10 An equity market-neutral manager would adjust the net exposure of the trade on an ongoing basis to ensure that it remains beta-neutral. In fact, the process of
rebalancing the entire portfolio to ensure neutrality of all factors, is critical to the success of an equity market-neutral strategy.
11 Reviewed by Jeremy Evnine, Evnine & Associates, Inc. and Jeffrey L. Skelton, Symphony Asset Management.

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Glossary of Key Terms calculated as the ratio of the mean return minus the risk-
free rate (excess return) to the standard deviation. The
Efficient Market Hypothesis (EMH): The theory that higher the Sharpe Ratio, the more favourable the
all information is already accounted for in stock prices, risk/reward trade-off.
making it impossible to beat the market.
Short (Interest) Rebate: A portion of the interest in a T-
bill account earned by a hedge fund from shorting a
Gross Market Exposure: Long exposure + (absolute
security. When selling a stock short, a hedge fund
value of) short exposure. Therefore, a typical equity
borrows the stock from a prime broker (who borrows it
market-neutral portfolio with $1 long + $1 short has from an existing shareholder) and the short sale’s
gross market exposure of 200%, but net market exposure proceeds are typically held in a T-bill account with the
of zero. This portfolio is not deemed to use any leverage. prime broker as collateral. Much of the T-bill interest is
then rebated to the hedge fund. (Note: The hedge fund
London Inter-Bank Offered Rate (LIBOR): The must pay dividends to the original shareholder.)
interest rate that the banks charge each other for loans in
global capital markets (i.e., Eurodollar rates). This rate Short Selling Stock: Borrowing shares to sell in the
applies to the short-term international inter-bank market open market with the goal of buying these shares back at
for large loans and is a benchmark for other short-term lower prices in the future, and at that time, returning the
rates. shares to the lender.

Skewness: A measure of the asymmetry of the

Kurtosis: A measures of the peakedness/flatness of the
probability distribution. A distribution or data set is
probability distribution. A normal distribution has a
symmetric if the left and right side of the distribution at
kurtosis of 3.0, which is often rescaled to 0.0 when it is the mean are mirror images, and the distribution
known as “excess kurtosis.” A kurtotic distribution has therefore has a skew measure of 0.0. A distribution has
more observations clustered around the centre and tails, positive skew (right-skewed) if there are more
relative to a normal distribution. A high kurtosis observations on the right side than the left side, and
distribution has more weight in the tails and less in the negative skew (left-skewed) if the opposite is true.
centre, and a low kurtosis distribution is the opposite.
High kurtosis means that more of the variance is due to Technical Analysis: A method of forecasting security
infrequent extreme deviations, as opposed to frequent prices and market direction by examining patterns of
modestly-sized deviations. variables such as trading volume, price changes, rates of
change, and changes in trading volume, without regard to
underlying fundamental market factors.
Omega Ratio: A ranking function based on the return
distribution of an asset. It is calculated at a threshold and
Uptick Rule: A rule established by the securities
considers all of the moments of a distribution including
commissions that selling a stock short can only be done
skew and kurtosis. Most important, it distinguishes on an uptick, that is, when the most recent movement in
between upside and downside volatility. The Omega the stock’s price has been an increase. In the U.S., a short
Ratio is a relative measure of the likelihood of achieving sale can also be done on a “zero-plus tick” (i.e., at the
a given return (e.g., a minimum acceptable return same price as the previous board-lot price, but at a higher
[MAR]). The higher the Omega value, the greater the price than the last different price; also called a zero
probability that a given return will be met or exceeded. uptick). However, in Canada, short sales are also allowed
based on a “flat-tick rule,” where the price is not below
Sharpe Ratio: A ratio based on the first two moments of the previous board-lot price. Hence, a short sale can also
the return distribution (i.e., the mean and the variance), be done at any price other than a down tick (i.e., at an
“up tick”, a “zero-plus tick” and at a “zero-minus tick”).

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Bibliography Notes to Strategy Paper Series:

1. “Absolute Returns,” by Alexander Ineichen, (John ▪ Educational Materials: This document is designed
Wiley & Sons, 2003). solely for information and educational purposes. The
examples used have generally been simplified in
2. “Managing Risk in Alternative Investment order to convey the key concepts of the hedge fund
Strategies,” by Lars Jaeger, (Pearson Education trading strategy.
Limited, 2002).
▪ Hedge Fund Strategy Performance Data: The
3. “Market Neutral Investing,” paper by BARRA statistical data on the hedge fund strategy presented
RogersCasey Research Insights, 2000. in this paper is both end-date sensitive and period
sensitive. We have used the period and end date in
4. “The Jungles of Randomness: A Mathematical this paper, as it reflects the overall performance of
Safari,” by Ivars Peterson, (John Wiley & Sons, the hedge fund strategy for the longest period to date
1998). (at the time of writing), based on available data from
Hedge Fund Research Inc. (HFRI). Different periods
5. “An Approach to the Non-normal Behavior of and end dates may result in different conclusions.
Hedge Fund Indices using Johnson Distributions,”
by Pedro Perez (September 2004), presented to ▪ Past and Future Performance: Past performance is
Finance Department, ESSEC in Paris and submitted not necessarily indicative of future results. Certain
for publication. information contained herein has been obtained from
third parties. While such information is believed to
be reliable, AIMA Canada assumes no responsibility
for such information.

▪ Disclaimer: None of AIMA, AIMA Canada, its

officers, employees or agents make any
representation or warranty, express or implied, as to
the adequacy, completeness or correctness of this
strategy paper. No liability whatsoever is accepted
by AIMA or AIMA Canada, its officers, employees
or agents for any loss arising from any use of this
strategy paper, or otherwise arising in connection
with the issues addressed in this strategy paper.

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© 2006 AIMA Canada