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.
When these funds first became widely available, in 1997, investors weren’t looking to avoid the vicissitudes of the equity market. They were looking to ride the market’s waves. The Barr Rosenberg Market-Neutral Fund, the very first such fund, launched in 1997 with a promise that it would deliver a steady 6 percent above Treasurys. The fund promptly went out and dropped 1.1 percent in its first year, while the dot-com boom was roaring and the S&P was up by more than 28 percent. In 1999, the Barr Rosenberg fund fell another 11.7 percent, while the S&P 500 was returning 21 percent.
But this environment is very different from that of the late 1990s, and some market-neutral vehicles have been much more successful lately. The market crash of 2008-2009 left a lot of people wishing their returns were more divorced from those of the larger market. But keep in mind, the benefits of market-neutral investing can mitigate a drop in equities, but can’t completely avoid it. During 2008, while the S&P 500 was dropping by 37 percent, the typical market-neutral fund was able to avoid much of that loss, but still lost around 7 percent.
Of course, some market-neutral funds did manage to post gains. Highbridge Statistical Market-Neutral was up 9.79 percent in 2008, a stunning performance in that market environment. But the problem is that such a fund, in avoiding the larger market’s losses, also avoids its gains. Over the past three years, while the S&P has been up by more than 20 percent, the Highbridge fund has lost just over 2 percent.
The best-performing of these funds, over the long term, may be the TFS Market Neutral Fund, rated No. 1 by Lipper in its category over the past five years. It’s returned more than 5 percent over the past five years, while the S&P was gaining just 2 percent. The managers have done an excellent job of divorcing their returns from the market’s; the TFS fund has a beta of a minuscule 0.23 percent, while its alpha is 4.67 percent.
QuantShares has become a leader in this area, often with a set of paired funds that take directly opposite tacks. The QuantShares U.S. Market Neutral Momentum Fund, for instance, buys the stocks with the highest price momentum and sells short the stocks with lowest price momentum, while the QuantShares U.S. Market Neutral Anti-Momentum Fund does the exact opposite. As long as there’s equal movement in opposite direction, the fund should approach market neutrality.
Even if you’re not expecting another market crash, there’s a place for market-neutral funds in most portfolios. Five to ten percent is a common recommendation, to use simply as a hedge. In the name of diversification, it’s nice to know there’s a relatively safe instrument that won’t correlate with the equity markets.