Market-neutral strategies profit from identifying and exploiting mispriced securities while eliminating the impact from market movements. In this piece, we provide a straightforward overview of a market-neutral approach within a mortgage strategy. If markets were completely efficient, then a fully hedged portfolio would earn the risk-free return. It would be irrational for a manager to go through the process of strategy building and portfolio management when simply purchasing T-Bills would produce the same outcome. In reality, market inefficiencies do exist and the most skilled managers capitalize on them to generate a persistent stream of positive risk-adjusted returns by prudently taking calculated risks. In general, the goal of a fixed-income arbitrage strategy is to hedge out the unwanted (market) risks while generating returns through exploiting pricing inefficiencies (sector/security). In a mortgage strategy, the most persistent source of return is hedge-adjusted carry – income earned net of hedging costs. Other sources include statistical arbitrage and opportunistic purchases of fundamentally undervalued securities.
Interest Rate Risk
The primary driver of returns in a fixed-income security is its duration, or interest rate sensitivity. This is the foremost source of market risk, and successful market-neutral strategies buffer the portfolio against it by implementing a hedging strategy to maintain a near-zero duration with minimal yield curve exposure. An optimal mix of hedges (cost and efficacy) are selected to offset the partial durations of the portfolio’s core investments. Treasury and Euro Dollar futures and options are commonly used to hedge duration.
Movements in spreads (risk premia) also affect the valuation of fixed income securities, and sensitivity to this risk factor is measured by spread duration. Risk premia can increase for a variety of reasons. Some of the main drivers include expectations of weakening market fundamentals, the ensuing effects of an increase in volatility, and intermittent technical factors causing a glut of supply. Spread risk can be offset using a variety of hedging instruments. Swaps and swaptions are effective hedges against interest rate volatility and broad market moves in risk premiums, while mortgage securities and the mortgage basis can be used to offset phenomenon that are more local to the mortgage market. Value-at-risk (VaR), an industry standard risk metric, can be used to measure spread risk using historical spread volatility for the types of securities held in a portfolio and to manage the exposure to be within an acceptable bound (e.g. 2%). By managing this risk within a range, the strategy accomplishes two things: 1) the ability to generate hedge-adjusted carry is not impaired from over-hedging and 2) as deemed necessary, the resulting savings can be used for tail hedges to further protect against systemic risk.
Risk Adjusted Returns
Tradex delivers a market-neutral product in its multi-strategy mortgage portfolio with the aim of providing investors with an all-weather investment resource that generates persistent alpha through a return series that exhibits reduced volatility and low correlations to traditional and alternative investments.
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Vesta Marks, CFA, CAIA