The Market-Neutral Investment Process The process is broken down into three basic steps: the initial screen, the stock selection process, and the nal portfolio construction. The initial screen limits the universe of stocks that are to be considered for the portfolio. This is rather straightforward but differs from manager to manager. The stock selection process is the most involved step and often involves building a model. The nal portfolio construction step differs in importance depending on how much manager discretion is left in the overall process.

Stock Selection Once a manager has limited his selection universe, he can begin to decide which stocks are to be included in the portfolio. During the stock selection process, managers are looking for quantied metrics that have strong predictive value across a wide range of stocks. For most managers, the use of these metrics involves the creation of a multifactor model that can be used to rank all of the stocks in an investment universe. Some managers create models based on fundamental data; others use technical data or a combination of the two. The standard form used in the creation of most market-neutral models is a linear equation with n terms: r = bf1 + bf2 + bf3 + . . . bfn r = the expected return of the security b = is the sensitivity of r to the respective factor, f

The predictive value can be determined using linear regression, as discussed in Chapter 2. Each factor serves as an independent variable and the reccc_ehrman_ch09_125-132.qxd 11/9/05 12:56 PM Page 129 129 Reviewing the Elements gression coefcient for each becomes the respective weighting within the model.

THE ARBITRAGE ELEMENT The most basic denition of an arbitrage trade is one that seeks to exploit an inefciency in the market by buying a security and simultaneously selling it for a prot. While certain market inefciencies do still exist, the majority of arbitrage activity today is based on perceived or implied pricing aws rather than on real ones. In other words, these pricing aws are not the result of incomplete or untimely information, but rather represent statistically signicant anomalies of divergence from historically established average price relationships. In simple terms, relative-value arbitrage is the activity of taking offsetting positions in securities that are historically or mathematically related but are currently related in ways considered temporarily distorted. Thus, the most important feature of arbitrage, particularly in terms of how it relates to pairs trading, is the convergence of these aws back to their expected values.