This is a convergence trading strategy that is designed to generate returns independent of what happens to the overall market. It does this by attempting to neutralize all or most market directional risk (aka systematic risk or beta) as well as sector risk. With this strategy the focus is on stock selection. So if you are a great stock picker, you may be able to apply some of the ideas of this strategy to your own portfolio.
Central to this strategy is the concept of "one alpha." One alpha means that this strategy produces a return from a single portfolio that has both long and short positions which in total produce no market exposure. This is different from the equity long/short strategy in that the equity long/short strategy has market exposure and produces returns from two different portfolios, one long and one short. Here, the focus is on one portfolio as a whole that consists of both long and short positions that on the whole has an equal dollar amount invested in both long and short positions and produces no exposure to market risk. This is known as the "rule of one alpha." When a portfolio manager follows the rule of one alpha, the portfolio he constructs will depend on stock selection as its source of return because there will be no return from exposure to market risk-the portfolio will have no beta or systematic risk exposure and the return to the portfolio will not depend on the moves of the broader market. Although there is leverage involved in the shorting of stocks, beyond this there is no leverage used in this strategy.
To apply this strategy a bottom up approach is taken. Bottom up means you start at the company level with the analysis. The goal is to find out what financial variables drive the price of the stocks. In this approach the financial data of the individual stocks, and not economic data, is looked at when selecting stocks for the portfolio. It is easy nowadays to simply go online to one of the many financial sites and get a ton of free data on the various financial ratios and financial condition of a stock as well as its industry. The amount of financial analysis (as well as what it means) you can do over the internet on a publicly traded company is only limited by your time and energy. Therefore, I will not waste anyone's time on explaining information that can be easily found with a simple search on the internet….
Risk, simply stated, is uncertainty concerning what will happen in the future. Is it realistic to expect that a neutrally constructed portfolio can avoid all market risk, credit risk, currency risk, industry risk, and all the other kinds of risk? Probably not…. I don't know of any industry that is not impacted to at least some degree by broader economic forces, and it would be very difficult, if not impossible, to perfectly offset the risk of each individual stock in a portfolio, no matter how good your analytical skills or how powerful your computer is. The key thing for individual investors and traders to remember is that risk should be utilized and managed as best as possible - risk should be understood and exploited.
As far as which stocks should be chosen for inclusion into the portfolio, many funds use computer models that measure the risk involved. Obviously, an individual investor would not have access to these models, but many investors do have extensive experience and knowledge that they could apply in constructing a portfolio using this strategy. This is, of course, not ideal and the resulting portfolio would not be perfectly neutral, but nonetheless an individual investor could at a minimum reduce the amount of risk he is exposing himself to and get a better risk adjusted return in the process. -John Bardacino