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.