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.”
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.