From the April 2010 issue of Investment Advisor • Subscribe!

April 1, 2010

Expert's Corner: Putting It in Neutral

How you can improve a client's portfolio by using a market neutral strategy

With every bear market the discussion as to whether "buy and hold" works invariably resurfaces. It will be analyzed in journals, opined over in the mainstream media, and spun into the sales pitch du jour for active management. Then we enter the next bull run and investors simply don't pay attention anymore. Or perhaps they assume that end-date bias is the culprit, so why don't we just pick a different end date and be done with it? Well, that only works if you aren't within a few years of retiring or your stomach is made of iron.

Part of that discussion will also focus on asset allocation:

o Strategic asset allocation: the determination of your overall mix between distinct asset classes.

o Dynamic asset allocation: the maintenance of those target allocations through rebalancing according to a set schedule, or upon a set divergence from the targets.

o Tactical asset allocation: the slight contrarian massaging of target allocations based on recent extreme performance in which one would increase their target allocation to, say, U.S. stocks after they had declined by 40%. They would decrease their target allocations to high-yield bonds if they had been the runaway best performer for the past year, too.

Dynamic and tactical asset allocation don't really need re-thinking as much as strategic asset allocation. The end goal of strategic asset allocation is to find distinct asset classes that tend to behave differently with respect to one another. Normally this holds true when markets are humming along, but you get those black-swan events (2008 anyone?) which have driven correlations of asset classes to one just when you needed diversification to work most for you and for your clients.

Tied to the Business Cycle

Here's the problem. Traditional asset classes are all tied to the business cycle. In fact, many alternative asset classes are tied to the business cycle as well. Why? Because if GDP is falling, businesses are not making as much money and they are failing. With lower employment comes less spending. With lower spending, lending money for people to start and maintain businesses seems unattractive, so interest rates are lowered to the point people start borrowing again, but that means returns from fixed income are low. While this is obviously a blunt 30,000-foot perspective, you can see the ramifications for absolute returns.

Wouldn't it be great if you could find an asset class that wasn't tied to the business cycles of the world? Well, today's your lucky day because there are numerous commodity trading advisors, also known as CTAs, who run market-neutral strategies that couldn't care less if GDP, equity markets, or fixed-income markets are rising, capitulating, or on vacation.

Defining Market Neutral

What's in a name? Well, in this case, all you need to know. Okay, perhaps you need to know more, such as that market neutral strategies have earned a bad rap through their association with hedge funds. But forget what you think you know about market neutral strategies (and hedge funds for that matter, since it's the bad ones that got all the press), and let's start with a tabula rasa.

A market neutral strategy is any investment strategy whose success is independent of systematic risk, the general ebb and flow of the markets. In fact, you could go one step further in saying that market neutral strategies really only care about non-systematic factors. This might seem counter-intuitive to Modern Portfolio Theory (MPT) which tells us that the only free lunch in investing is the reduction of non-systematic risk by adequate diversification within a market. But remember, a market neutral strategy operates independently of the market, so we're not seeking Beta (exposure to the market).

Let's take a look at a specific example of a market neutral strategy. Let's use Research in Motion and Apple Inc. as an example. Suppose we think that Apple is going to do better than RIM in the future. You could take a long position in AAPL and take an equal weight short position in RIM. Since you have X number of dollars in a long position but an equal number of dollars in a short position, you have no net market exposure.

In fact, if Apple and RIM both went down 20% there would be almost no drop in your portfolio. Conversely if they both appreciated 20%, again there would be almost no increase in your portfolio. This is because in both cases your gain in the long (or short) position is offset by your loss in the short (or long) position. Voila! A market neutral strategy.

But let's look at what happens if your original assumption was correct, that Apple would do better going forward. No matter what happens to the market, so long as Apple does indeed fare better than RIM, you are making money since you went long Apple and short RIM. Let's say the market overall was on a tear, and Apple went up 20% and RIM went up 15%. Your long position made 20% and your short lost 15%, so net-net, you're ahead. What about during a horrible bear market? The overall market could be down 50%, and Apple could be down 55% and RIM down 60%, but you still made money in this strategy because your long position lost less than your short position earned. Again, so long as Apple fares better than RIM this market neutral strategy doesn't care what the overall market does.

Less Risk Than Long-Only Equity...And Fixed Income, Too!

From January 1990 to December 2009 the index of market neutral strategies kept up with equities and did so with less volatility than bonds (see table above, right).

The Hedge Fund Research Institute (HFRI) Market Neutral Index has data going back to January 1990, and the evidence is compelling. Further, Edgar Peters, when he was CIO of Panagora Asset Management, wrote an article titled "Is Asset Allocation Still Working?" which cited that the correlation of returns of the HFRI Market Neutral Index with the subsequent year's growth in GDP was very small, which is the opposite to the high correlation exhibited by stocks (proxied by the S&P 500).

This further lends credence to the notion that market neutral strategies are in fact market neutral, and further are not tied to the business cycle.

Don't take all of this to mean that market neutral strategies are infallible. Simply, if RIM outperformed Apple in our example from above then we can see that this market neutral strategy is certainly capable of negative returns as well.

Access To Market Neutral Strategies

Where does one access a market neutral strategy? Well, certainly you could do it yourself with individual stocks for your clients, but the amount of time it would take and the compliance nightmares encountered with all the short positions would probably not be a welcome prospect.

You could find a hedge fund as an alternative, or you could engage a CTA through a fund of fund managed futures trading program which would not only add market neutral strategies to your portfolios but also include other managed futures trading strategies that may be equally compelling. In both of these cases you would lighten the administrative load considerably for your practice.

In conclusion, if these strategies can provide decent returns, excellent risk-adjusted returns, and low correlation to traditional asset classes, then it's pretty clear that they warrant some due diligence on your part for possible inclusion in portfolios.

The evidence is very compelling, and if you are a fan of diversification, then simply the appeal of an asset class that is not tied to the business cycle in your portfolios is probably reason enough for adoption.

A small dose of a strategy that is independent of the markets, a market neutral strategy, might be a great way to put your client portfolios into top gear.


Robert J. Lindner, CFP, is founder of Lindner Capital Advisers (www.lcaus.com), an advisory firm and third-party asset manager in Marietta, Georgia, that integrates a managed futures component into the portfolios it manages for clients of financial planners and wealth managers. He can be reached at rlindner@lcaus.com.
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