With last year’s market-wide slump, mutual funds are trying to take a play out of the hedge fund playbook. One of the more common strategies employed by hedge-like funds is market neutrality. By taking off-setting positions in equities, fixed-income securities, options, etc., managers can eliminate market risk.

Market neutrality conceptually works like this: If a fund manager believes that Visa will outperform Master Card, he can eliminate the market risk by buying Visa and short-selling Master Card in equal amounts. Assuming Visa does outperform Master Card and the market is on an upswing, the long position in Visa gains more than the short position in Master Card loses. Furthermore, if the market falls, but Visa still outperforms Master Card, the short position in Master Card gains more than the long position in Visa loses. No matter which way the market moves, the fund has made a net profit.

In practice, the math is more complicated. The beta of the short position has to be equal to the beta of the long position, so market moves affect the two positions equally but in opposite directions. Furthermore, the portfolio manager could short the market through one of the available short-selling or inverse ETFs and match the beta of his long holdings to 1, which represents the beta of the market as a whole.

While eliminating market risk is a valuable tool, market neutrality does not eliminate all risk and in fact, creates some unique risks. Market neutral positions won’t make as much profit in an aggressive bull market as traditional long positions. Also, if the manager picks a stock to outperform another stock, and the opposite happens, the fund will produce net losses whether the market goes up or down. Furthermore, the downside risk to the short position is theoretically unlimited because stock prices are not bound to an upper limit. Another unique risk to the market neutral strategy called “beta mismatch” . If the beta of the long position is larger than the short position, a market downturn should cause the long position to lose more, as it has a higher correlation to the market as a whole. Furthermore, if the beta of the short position is larger, a market upswing should increase the short position’s loss more than the long position’s gain.

Market neutrality has been one of the more popular hedge fund strategies over the years, and this popularity could be extrapolated to the hedge-like mutual fund sectors. Investors should see a large rise in the number of available market neutral mutual funds.

Read Part 3 Long/Short Mutual Funds

Read Part 1 Mutual Funds Emulate Hedge Funds