# Market Neutral Strategy: Definition, Benefits, and Risks Explained

> **Definition**
>
> A market-neutral strategy is an investment approach that aims to profit from both rising and falling prices in the market while minimizing exposure to overall market risk.

## What Is Market Neutral?

A market-neutral strategy is a type of investment strategy undertaken by an investor or an [investment manager](https://www.investopedia.com/terms/i/investment-manager.asp) that seeks to profit from both increasing and decreasing prices in one or more markets while attempting to completely avoid some specific form of market risk.

Market-neutral strategies are often attained by taking matching long and short positions in different [stocks](https://www.investopedia.com/terms/s/stock.asp) to increase the return from making good stock selections and decreasing the return from broad market movements.

### Key Takeaways

*   Market-neutral strategies aim to profit from both rising and falling markets while avoiding specific market risks.  
    
*   These strategies often involve taking equal long and short positions in different stocks.  
    
*   Market-neutral strategies are popular among hedge funds focusing on absolute returns.  
    
*   Fundamental and statistical arbitrage are the two main types of market-neutral strategies.  
    
*   Market-neutral funds tend to perform well during high market volatility due to their focus on market risk mitigation.

## In-Depth Look at Market Neutral Strategies

There is no single way to implement a market-neutral strategy. Beyond the method mentioned above, market-neutral strategists may also use other tools such as [merger arbitrage](https://www.investopedia.com/terms/m/mergerarbitrage.asp), shorting sectors, and so on.

Managers who hold a market-neutral position are able to exploit any momentum in the market. [Hedge funds](https://www.investopedia.com/terms/h/hedgefund.asp) commonly take a market-neutral position because they are focused on absolute as opposed to [relative returns](https://www.investopedia.com/terms/r/relativereturn.asp). A market-neutral position might mean holding 50% long and 50% short positions in industries like oil and gas or in the broader market.

Often, market-neutral strategies are likened to [long/short equity](https://www.investopedia.com/terms/l/long-shortequity.asp) funds, though they are distinctly different. Long/short funds simply aim to vary their long and short stock exposures across industries, taking advantage of undervalued and overvalued opportunities.

Market-neutral strategies, on the other hand, focus on making concentrated bets based on pricing discrepancies with the main goal of achieving a zero beta versus its appropriate market index to hedge out systematic risk. Although market-neutral funds use long and short positions, they have different goals than regular long/short funds.

## Exploring Different Market-Neutral Strategies

There are two main market-neutral strategies that fund managers employ: fundamental arbitrage and statistical arbitrage. Fundamental market-neutral investors rely on fundamental analysis to predict stock price changes, instead of using algorithms.

[Statistical arbitrage](https://www.investopedia.com/articles/trading/07/statistical-arbitrage.asp) market-neutral funds use [algorithms](https://www.investopedia.com/terms/a/algorithm.asp) and quantitative methods to uncover price discrepancies in stocks based on historical data. Then, based on these quantitative results, the managers will place trades on stocks that are likely to revert to their price means.

A major benefit of market-neutral funds is their focus on building portfolios that reduce market risk. In times of high market [volatility](https://www.investopedia.com/terms/v/volatility.asp), historical results have shown that market-neutral funds are likely to outperform funds using other certain strategies.

Except for pure short-selling strategies, market-neutral strategies historically have the lowest positive correlations to the market specifically because they place specific bets on stock price convergences while hedging away the general market risk.

## Case Study: Vanguard’s Market Neutral Investor Fund

As a market-neutral strategy, the Vanguard Market Neutral Investor Shares Fund (VMNFX) is a [liquid alt fund](https://www.investopedia.com/terms/l/liquid-alternatives.asp) using long and short strategies, unlike other [mutual funds](https://www.investopedia.com/terms/m/mutualfund.asp) that stick to long positions. The fund's strategy aims to minimize the impact of the stock market on its returns, meaning the fund's returns may vary widely from those of the market.

Although most funds that short stocks, such as hedge funds, do not disclose their short holdings because SEC rules do not require them to, the Vanguard Market Neutral Investor Shares does publish its shorts.

It chooses short positions by evaluating companies in five categories: growth, quality, management decisions, sentiment, and valuation. Then, it creates a composite expected return for all of the stocks in its universe and shorts those with the lowest scores.

Investing in market-neutral specific funds is typically for high-net-worth individuals. For example, VMNFX has a minimum investment amount of $50,000. Other funds may have extremely high [expense ratios](https://www.investopedia.com/terms/e/expenseratio.asp), well above the investment ratios of [passively managed](https://www.investopedia.com/terms/p/passivemanagement.asp) funds.

> **Article Sources**
>
> 1.  Vanguard. "[Vanguard Market Neutral Fund Investor Shares (VMNFX)](https://investor.vanguard.com/mutual-funds/profile/VMNFX)."