Despite the strong performance shown by the stock market over the first quarter of 2012, many investors are still wary of its long-term prospects. Either they are concerned about the underlying fundamentals of stock and the macroeconomy, or they think that the strong returns from the first three months must necessarily cool down in the near future.
That sort of uncertainty has been good news for the growing field of market-neutral investing. As the name implies, market-neutral investing aims to provide steady returns independently of where the larger market is headed. Of course, this makes them more valuable in down or middling market environments rather than during a bull. Morningstar listed 29 such funds as of last September, as well as 12 ETFs.
Of course, they’re hardly a new idea. Investors have been trying to protect themselves from the vagaries of the market for decades, if not centuries. The first-ever hedge fund, run by A.W. Jones & Co., was founded in 1949 with the explicit mission of providing returns separate from the market’s moves. Founder and manager Alfred Winslow Jones carefully bought and sold equivalent amounts of stock so that his returns would reflect only his own acumen, and not simply the movement of the larger market.
But for a long time, such strategies were restricted to hedge funds. Prior to 1997, mutual funds were restricted from taking more than 30 percent of their profits via short-selling, and short-selling is an integral part of a market-neutral strategy. The Taxpayer Relief Act, passed that year, eased that restriction and paved the way for mutual funds to offer true market-neutral vehicles.
That new regulation freed up funds to take both long and short positions in different stocks. The thinking behind the strategy is that fund managers will make more from their long positions than they lose in their short positions during up periods for the overall market. And when the market drops, they’ll take bigger profits from their shorts than they will losses from their longs.
Market-neutral funds are part of a larger category called long-short funds, which employ both long and short purchases of stocks as part of their overall strategy. Not all long-short funds, though, are market-neutral; some of them use those tactics simply to boost their overall returns. But like strictly market-neutral funds, any funds with a heavy reliance on shorts will perform better when the larger market is struggling.