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Wheat from Chaff

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The idea behind market neutral mutual funds is incredibly alluring. By owning a portfolio of attractive stocks while simultaneously betting against a number of weak companies, generating an attractive rate of return in both bull and bear markets goes from the stuff of dreams to a tantalizing possibility.

Unfortunately, the difference between perception and reality has disappointed a number of early entrants in these funds, a specialty so narrow that fund ratings behemoth Morningstar had until onlyrecently lumped such offerings into its catch-all “hybrid” fund category. But among the many failed attempts at creating a true market neutral fund with attractive returns and moderate risks there are a few unsung heroes who have managed to pull off this feat. Their funds may fit well with clients who are uncomfortable with the current state of the domestic equity markets.

A Rocky Start

Until a few years ago, mutual fund managers who wanted to protect shareholders against falling stock prices were limited in what they could do. A six-decade-old restriction known as the “short-short” rule barred mutual funds from generating more than 30% of their gross income from gains held less than three months or from short sales, in which borrowed stock is sold with the hope it can be replaced with shares purchased at a lower price.

Then Congress passed the Taxpayer Relief Act of 1997, which did away with the short-short rule. Besides removing a troublesome constraint for existing funds, the rule change resulted in the advent of so-called market neutral mutual funds, which attempt to generate returns while eliminating a majority of the market’s risk. Long-short funds, which generally attempt to produce meatier returns with more volatility, were also developed.

Both types of mutual funds are managed in similar fashion. First, the fund manager takes a long position in stocks that he or she expects to appreciate in value, while short selling those issues that are expected to decline. As long as the stocks owned have similar characteristics to those that are shorted, the positions should offset each other–at least in theory. But that doesn’t mean that market neutral funds always perform as advertised.

Take the AXA Barr Rosenberg Value Market Neutral Fund (BRMIX), one of the first funds developed after the 1997 rule change. The fund’s operator was quick to point out in marketing presentations that the strategy had generated eye-popping returns of 15% per year in the eight years preceding the fund’s launch with negligible correlation to the S&P 500 index–a combination that many investment advisors found hard to resist.

Unfortunately, the fund hasn’t lived up to its hype; after losing money steadily from inception through the end of 2000, its assets have dropped from a high of $400 million to about $59 million, according to data provided by Morningstar.

What would cause such a performance imbroglio? According to AXA Rosenberg, the fund tends to buy value stocks and short growth stocks. Since the late 1990s favored go-go issues such as Yahoo! and Netscape over more staid insurance and banking stocks, the fund’s overall portfolio declined steadily. But the fund seems to have found its sea legs now that value stocks are back in vogue; through mid-July 2001, its shares are up about 7% for the year.

Still, the early experience with the AXA Rosenberg fund soured many advisors on the market neutral investing concept. One prominent advisor who lost a chunkof his client’s assets by investing in the fund said the experience has led him and other advisors to be gun shy about investing in any market neutral products. Other advisors are more blunt. “Not only did the fund fail to make money,” says Lane Carrick, president of Sovereign Wealth Management in Denver, “it also added a ton of volatility to client portfolios. It was a failure in every sense of the word.” (The author is chief investment officer at Sovereign Wealth Management, but was not employed at Sovereign at the time of the initial client investment in BRMIX.)

Still searching for diversification, many advisors shifted gears from market neutral mutual funds to market neutral hedge funds, which are unregulated partnerships only available to wealthy clients–and which, unlike mutual funds, have largely performed as advertised.

Fewer Constraints, Better Performance

Even though the 1997 rule change allowed mutual fund managers more freedom to utilize client assets, they are still not as unencumbered as their hedge fund brethren. For starters, mutual funds formed under the Investment Company Act of 1940 are restricted from creating a concentrated position of 25% or more of the fund’s assets, even if that position is in cash. As a result, many market neutral funds wishing to maintain a large cash position may be forced to buy or sell securities they really don’t want, just to stay in line with current legislation. Mutual fund pros are also restricted in the amount of margin (money borrowed on stock owned) they can hold, and they are only allowed to maintain 50% of client assets in short positions.

Another difference is related to the liquidity available to investors. Mutual funds are almost always open for new money or for redemptions at the end of each trading day, which means that managers must have enough cash on hand in case investors want to bail out of the fund suddenly. Hedge funds, on the other hand, usually allow investors to head for the exit door only at the end of each month or each calendar quarter. This allows for more efficient position paring if client redemptions outpace new additions.

The result of these rather esoteric differences amounts to a significant bifurcation in returns. According to the VAN U.S. Hedge Fund Index, a widely cited bogey for alternative investments, market neutral hedge funds posted a net compound annual return of 20.4% from 1996 through June 2001, with only one losing quarter. This type of performance has been equaled by less than a handful of the best performing equity neutral mutual funds.

“Clearly, market neutral hedge funds have an advantage over their mutual fund counterparts,” says Meredith Jones, director of research for VAN Hedge Fund Advisors International, a Nashville-based consulting firm. “Should a hedge fund manager perceive that the markets are too choppy or irrational, [he] can retreat to a large cash position. Furthermore, hedge funds are not tied to daily liquidity. In fact, if it is not advantageous for the fund to pay out redemptions even by the terms of the offering, most of them have the ability to suspend redemptions until market conditions improve. Obviously, most do not want to invoke this privilege, but it gives the manager the leeway to manage money for returns and not redemptions.”

Culture Clash

The big difference in returns between mutual funds and hedge funds comes as no surprise to Brian Cornell, managing director at Chicago-based Mesirow Financial. As a portfolio manager responsible for overseeing about $1.6 billion in hedge fund assets, Cornell is well versed in separating the wheat from the chaff in active management. His biggest concern about market neutral mutual funds is “the huge cultural differences” that exist between them and their hedge fund counterparts.

“It is quite common for established mutual fund managers to migrate toward a hedge fund structure, either because of the lack of constraints in the hedge fund realm or the opportunities to make more money,” Cornell says. “But typically, these managers run the long portion of their portfolio as usual, while shorting at the index level in order to protect the downside. Some may even run their short portfolio by screening for longs in reverse. That’s a big mistake. Since equities tend to go down twice as fast as they go up, and stock prices tend to rise about 75% of the time, short selling requires an entirely different skill set than traditional long-only investing.” In Cornell’s view, a classic market neutral manager “attempts to add value on both the long and the short sides.”

To add insult to injury, most market neutral funds sport higher fees than their hedge fund progenitors. “Long-short mutual fund investors pay a liquidity premium for the ability to buy and sell into such funds daily, and an administration burden because the average mutual fund client is much smaller than the average hedge fund client,” says Cornell.

Cornell’s recommendation for would-be market neutral mutual fund buyers is to focus on funds run by an established player that also manages a hedge fund with the same mandate.

A good example is Caldwell and Orkin Market Opportunity (COAGX), a fund with a five-star rating from Morningstar that boasts a ten-year return of 15.4% per annum.

The Caldwell fund has a lot in common with other ambitious market neutral funds. First off, it sports a modest amount of client assets under management than most well known long-oriented offerings. Their relatively small asset base makes these funds more able to adjust to changing market conditions, and helps to reduce transaction costs when they buy and sell securities.

Caldwell and Orkin’s fund shares another unfortunate attribute with other successful market neutral mutual funds–it is closed to new investment. The Merger Fund (MERFX), another extremely successful offering that buys stocks of acquired companies (it also sells short shares of the acquirer), boasts a stellar track record and has been closed for years. But that doesn’t mean that quality market neutral offerings are not available (see “Making the Grade” sidebar on page 104).

Past Life Experiences

For advisors intent on finding the next great market neutral offering, a quick glimpse at a fund’s past performance can give important clues as to how it operates. Take the Boston Partners Long/Short Equity Fund (BPLEX), for example. This offering has been a stellar performer as of late, scoring a 16.1% gain through mid-July 2001, after enjoying a return of nearly 60% in 2000. The year prior, however, saw losses of 14.3%–a year when the S&P 500 index was up over 20%.

Why was the Boston Partners Fund up so much during the tough market conditions of the last few years, but off in a banner year for stock investors? The most likely explanation is that the fund is buying value stocks while short-selling growth stocks. While academic studies support such a strategy, value doesn’t always shine; in fact, growth stocks have been known to outperform value stocks for years. If that happens again, funds with a value ’tilt’ like this one will likely suffer again.

Although performance analysis can be a useful tool in selecting market neutral funds, it doesn’t yield much information about Lindner Market Neutral Fund (LDNBX). This fund started out with a bear market strategy that was designed to outperform if stocks were in an established downtrend. This approach gave the fund a terrible track record; the fund’s operator has decided to try a market neutral approach and to switch managers, a move that has resulted in a decent three-year return and a five-star category rating from Morningstar. Even so, advisors are better off letting the paint dry on this fund’s strategy before jumping in.

One fund worthy of consideration is Leuthold Core Investment (LCORX). Although the fund isn’t lumped into Morningstar’s market neutral category, it should be. The reason? The fund’s beta–a measure of its relationship with the stock market–is nearly zero. This means that the return of the fund is much more dependent on manager skill (or alpha) than the general direction of equities. Credit manager Steve Leuthold’s diversification methodology, which includes bonds, foreign equities, and short sales, for his near- market-neutral returns.

Leuthold’s performance is stunning; with an average annual return of 14.2% over the last five years (the S&P 500 index gained 14.5% per year in the same time period).

But what makes this fund so unique is the risks taken to achieve this level of performance. The fund’s standard deviation is less than 10%, compared to about 18% for the S&P 500 index. This gives Leuthold Core Investment one of the most attractive risk-reward ratios in the mutual fund universe.

Looking Outside the Box

Some of the best market neutral funds are found in unlikely places. Consider Calamos Market Neutral (CVSIX), for example. Manager John Calamos is an expert at convertible bond arbitrage, a strategy that entails buying convertible bonds (fixed income securities that can be converted into shares of the company’s stock), and short selling the underlying equity to hedge out market risk. This methodology has produced a return of close to 10% per annum with less volatility than a ten-year Treasury note.

The performance of Calamos has but one hiccup, a small loss in 1994. One of the reasons for this was a marked lack of volatility in the stock market, a condition that creates especially difficult trading conditions for convertible bond arbitrage firms. An interesting way to counter this dilemma is buy purchasing shares of Pioneer High Yield (TAHYX). This fund specializes in “busted” convertible bonds (a convertible bond becomes “busted” when the stock price of the issuing company has fallen so precipitously that the chances of triggering its conversion into stock are remote). Because busted issues are especially credit-sensitive, they tend to rise in value when market volatility drops. As a result, they make an interesting combination with more traditional convertible arbitrage strategies.

As fund margins continue to feel the pinch of a shaky stock market, a number of new players, including industry titan INVESCO, have begun to roll out market neutral and long-short mutual funds. These new entrants are supplanting funds that have been shuttered due to poor performance, including Legg Mason Market Neutral Trust, Dreyfus Premier Market Neutral, and Puget Sound Market Neutral Portfolio. Obviously, the market neutral game is a tough one to win.