Pair Spotting !

Market Neutral Vs. Risk Free

Market-neutral strategy: A trading strategy that derives its returns from the relationship between the performance of its long position and the performance of its short positions, regardless of whether this relationship is done on the security or portfolio level. 

In a perfectly market-neutral portfolio, holding all other factors constant, the performance of the long portfolio and the performance of the short portfolio are perfectly explained by fluctuation in the general market. Net performance for the overall portfolio will be near zero because for every move up or down in the long portfolio, there will be an offsetting move in the opposite direction for the short portfolio (the beta of the portfolio will be zero). In such a case, the investor would expect to earn roughly the risk-free rate.

In a managed market-neutral portfolio, however, if the manager is skilled, the investor expects the long portfolio to outperform the short portfolio in rising markets and the short to outperform the long in falling markets, thus creating a consistently positive return regardless of market conditions. 

There are several types of market neutrality: share neutrality, dollar neutrality, sector neutrality, and beta neutrality. Each of these has a different impact on the portfolio and relates differently to pairs trading. Understanding each and how to apply it appropriately will directly impact the portfolio construction process.