Benchmarking Dollar-Neutral Portfolios with Market Beta
Summary
The document distinguishes dollar neutrality from market neutrality and addresses how to benchmark a dollar-neutral strategy with nonzero market beta. Equal dollar amounts on the long and short sides do not necessarily cancel market exposure. The response also corrects a conceptual confusion in the question: market neutrality is associated with hedging beta exposure, rather than simply matching the volatility of the two sides.
For a portfolio with a small positive beta, one answer proposes the CAPM expected-return benchmark: the risk-free return plus beta times the market risk premium over the period. A second response emphasizes that beta’s sign and magnitude should be checked, and describes beta in terms of relative volatility and correlation. The discussion is brief and offers no regression procedure or empirical comparison; its benchmark recommendation depends on the beta estimate and CAPM assumptions.
Key ideas
- Dollar neutrality means equal long and short dollar exposure, but does not guarantee zero market beta.
- Market exposure can be assessed through beta rather than dollar amounts alone.
- The proposed CAPM benchmark combines the risk-free return with beta times the market risk premium.
- The sign and magnitude of beta should be checked when characterizing a strategy’s market exposure.
- The responses provide a conceptual benchmark and do not demonstrate it with data.
Tags
Full text
# Benchmark of a Dollar Neutral Strategy # Benchmark of a Dollar Neutral Strategy > A dollar neutral strategy invests the same amount of money long and short without accounting for the volatility (risk) of either side. Depending on volatility you either end up positively or negatively correlated with the market. A market-neutral strategy eliminates the correlation to the market by hedging the long side with an equally risky (=same volatility) short side. E.g. A hedge of a stock portfolio with a short position on the S&P500 Future. The size of the short position is chosen in a way that the resulting strategy doesn’t correlate with the S&P any more. I have a dollar neutral strategy that is positively correlated with market but the value of net beta is not zero. What should be the appropriate benchmark for this strategy? Are there any methods to construct a portfolio that can be a benchmark for this strategy ( like regressing market returns with dollar neutral etc) ? ## Answer by nbbo2 (score 1) https://quant.stackexchange.com/a/74396 The initial passage you quoted https://www.quora.com/Whats-the-difference-between-market-neutral-and-dollar-neutral-strategy (by Martin Fröhler on Quora) explains the difference between dollar-neutral and market-neutral, but it is slightly garbled (the word "volatility' should be replaced by 'beta'). As to your question, the benchmark for a portfolio with a given beta (in your case slightly positive) is given by the CAPM equation. In your case it will be slightly different than the Risk Free Return, but not much, i.e. $R_F+β(R_M−R_F)$ for the time period in question, with Beta small but positive. ## Answer by demully (score 0) https://quant.stackexchange.com/a/50800 Please let me be sure I have this right. Your strategy is positively correlated with market; but the beta is non-zero. IS the beta positive or negative? if negative, your previous statement cannot be true; you have to mis-measuring something somewhere (happy to help)! If your beta is the right sign but <>1, then that just reflects the imperfect ability of models to predict reality! Beta is just the relative volatility of your output over input times the correlation of the model. Correlation will always be <1 unless you claim perfect predictive powers over the future :-) So beta <>0 becomes a measure of the volatility/variation of the your inputs here... that's the "signal" (relevant or not) tha you're chasing here... very best, DEM
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