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Market-neutral Funds: A Matter of Risk

By Hal M. Bundrick

NEW YORK ( MainStreet)--With a meager annualized return of less than 2% over the past five years, investors may be inclined to abandon ship on market-neutral funds. With high fees and rapid portfolio turnover combined with weak performance, what's the use? Andrew Clark, manager of alternative investment research at Lipper says it's a matter of diversification, not return.

"In terms of operating expenses alternative investment mutual funds can be pricey relative to their traditionally managed fund peers," Clark admits in a Lipper report."It is common for alternative funds to have annual operating expenses of around 1.5%, and some funds are considerably more expensive. However, we view them as primarily diversifiers of risk and not necessarily as return enhancers."

But the case against market-neutral funds is compelling, with an annualized return of only 1.7% over the past five years, well below the average annual return of U.S. domestic equity funds which ranges between 9.4% and 14.4%, depending on investment style. And considering the fact that market-neutral funds are generally 20 basis points more expensive than U.S. equity funds.

However Clark notes that the risk-return component of market-neutral funds is what sets them apart.

"Using downside deviations and maximum drawdown as initial measures of risk, market-neutral funds have a fifth or less risk in terms of downside deviation than do all U.S. domestic equity fund groupings, and a 25% to nearly 100% better maximum drawdown," Clark writes. "We offer an alternative view of market-neutral funds: Do not look just at their nonrisk-adjusted returns or their fees but rather at what they can add in terms of diversifying the risk of a portfolio."

The analyst says that taking into account the risk-adjusted performance of market-neutral funds, while investors would more than likely sacrifice returns in good markets, they could potentially protect returns in down markets.

In other words, in this case it's not what you make, but what you keep.

--Written by Hal M. Bundrick

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