Market Neutral Diversification for Individual European Investors: A Risk-Return Improving Strategy Under the Sand and an Appealing Niche for the ETF Industry

Abstract

This paper aims to empirically verify whether an individual European investor can enhance the diversification of his/her portfolio of financial assets by implementing an equity market neutral strategy. The analysis takes into consideration a typical European investor who has roughly diversified her financial investments and assumes that investors are risk-averse and have preferences characterized by a mean-variance model. We concluded that adding an equity market neutral can significantly improve the long term risk-return profile of a conventional asset allocation. The diversification benefits are realizable even with a little exposition to the market neutral and are more consistent for an investor who is allowed to go short. Investors who are willing to bear high levels of risk better appreciate the low correlation/ low standard deviation features of the equity market neutral. We also discuss how an individual investor who cannot afford a hedge fund can actually implement an equity market neutral strategy and point out that the appealing features of the equity market neutral open an interesting niche in the European exchange-traded fund (ETF) industry.

Keywords: Equity market neutral, Market anomalies, Efficient market hypothesis, Exchange traded funds, Portfolio diversification, Portfolio selection

JEL Classification: G11, G23