As stock prices continue to head north, investing in market-neutral funds seems like bringing an umbrella to a picnic.
As their name suggests, these funds are designed to shelter your assets from the effects of broad stock market moves, providing a hedge against a correction.
But with solid gains persisting on Wall Street, investors haven't seen much risk to hedge against. And even investors who see value in the funds' strategy have been disappointed with their poor performance.
Typically used as an aggressive alternative to income or cash holdings, these funds seek to match Treasury bill returns by dividing their assets into two portfolios: one for long stocks, or ones the managers think will rise, and one for short stocks, which are expected to fall. (Shorting, or short-selling, involves selling borrowed stock in hopes of buying it at a lower price later on.)
Although the short positions can keep these funds from bounding north when the market rises, they can significantly limit losses when stock prices pull back.
This strategy has long been employed in large institutional accounts. But retail market-neutral funds, introduced last year, have not lived up to their promise. Of the four best-known funds in the category, only
Lindner Market Neutral has a positive return this year.
"Intellectually we like the concept, but it's just been a disaster," says Harold Evensky, a financial planner in Coral Gables, Fla. He once typically put 5% of a client's portfolio in the
Barr Rosenberg Market Neutral fund to hedge against a market drop, but has moved his clients out of the fund, which has lost more than 13% this year.
Evensky and others blame the poor performance of market neutral funds on poor stock-picking. Since these funds are not correlated to the market in general or to any segment in particular, they don't benefit from any upward trends.
"If you make a mistake in a regular fund, the market will usually pull you along," says Frank Armstrong, a fee-based planner and president of
Managed Account Services
in Miami. "In this strategy you have to correctly pick both winners and losers, which doesn't leave much room for any errors."
"Why go through all this trouble and expense, not to mention taking all this risk, for a result that's just around Treasury bills?" he adds.
Evensky says the Barr Rosenberg fund's management team had earned a solid reputation running a similar strategy for institutional investors in the past. "I think the people running that fund are among the smartest in the industry, and if they can't make it work I don't know who can," he says.
Will Jump, a member of the Barr Rosenberg fund's management team, admits stock selection has recently been a problem. But he also blames the fund's troubles on an unusual market environment. "The stocks we've owned have posted better earnings than the stocks we've shorted," Jump says. "You'd think that would be a good thing, but it hasn't worked out."
Investor interest in market neutral funds has been lukewarm. The largest,
Phoenix-Euclid Market Neutral, has just over $90 million in assets, according to
. Some observers believe the best environment for these funds to gain investors' attention would be a sharp downturn for stocks, assuming the funds could perform well during a correction.
In fact, Eric Remole, portfolio manager of the
Warburg Pincus Long-Short Market Neutral
fund, finds himself in the unusual position of rooting against stocks. "The idea (behind these funds) is that the market will go down one of these days," he says.
Given the funds' short track records, it may be premature to give up on them. But if you're looking elsewhere for a hedge against a stock selloff, you might consider two of the more unique and aptly named funds you'll ever see:
Oppenheimer Real Asset fund and the
Started in 1997, the Real Asset fund is the only mutual fund designed to rise and fall with commodity prices, which historically have moved in different cycles than stock and bond prices. Managers Russell Read and Mark Anson invest in bonds that are linked to commodities. Since these bonds correlate to commodity prices, it wasn't a surprise when the fund followed commodities down last year, losing 45%.
Armstrong has kept his clients out of the fund, saying that while commodities are a useful hedge, he'd rather use a fund with lower expenses that tracks the
Goldman Sachs Commodities Index
. Evensky, however, did put clients in the fund, and they held their positions during recent weakness because the trouble was understandable. Unlike market neutrals, he said this fund fell because of commodity prices, not poor management.
"We talked to
the Real Asset fund's management about what was going on and we were comfortable," Evensky says. "I like the concept, and I knew what was wrong last year. With the market-neutrals, something is wrong and I don't know what it is."
Commodity prices have rebounded this year. Predictably, the fund has followed suit, rising nearly 23% in the year to date, according to Lipper.
The fund is expensive to own, however, and obviously can be volatile. There is a 5.75% front-end load on A shares and an annual expense ratio of 1.7%.
Unlike the market neutrals and the Real Asset fund, the Merger fund, started in 1982, has a long track record. As you might expect, the fund tries to profit from merger-arbitrage situations. When a merger is announced, the stock of the target company typically rises, while the acquiring company's stock often falls. So the fund buys the target company's stock and shorts the acquirer's stock.
Keep in mind, however, while this clever strategy reduces market risk, it does expose shareholders to the risk the deal could fall through. The fund aims for 10% to 15% annual returns. While it is up 11.3% this year, its returns have, on average, been close to or below 10% over the past decade.
If you're OK with that kind of performance, the fund might shine if stocks head south. Morningstar ranks it in the top 1% of all funds for bear-market performance.