Is a Market-Neutral Fund a Good Investment?

By Markdale Alternatives, Funds #investing 0 Comments

Should a market-neutral fund be part of your investment portfolio? The answer depends on your investment objectives, risk tolerance, and portfolio management style. But, while most investors should avoid market-neutral funds, others may think that market-neutral funds are a good way to achieve the best risk to return trade-off. This post will discuss some theoretical concepts that surround market-neutral funds and whether they might be good investments.

What is a market-neutral fund?

A market-neutral fund is a type of investment vehicle that aims to generate returns regardless of the overall direction of the financial markets. They employ a strategy known as market-neutrality, which involves taking long and short positions in various securities to offset market risk and focus on exploiting relative price movements between individual investments.

Market-neutral funds typically use a combination of long and short positions in different securities or asset classes. By taking both long (buying) and short (selling) positions simultaneously, the fund aims to minimize its exposure to broad market movements and instead capitalize on relative price differences between specific investments.

The primary objective of a market-neutral fund is to generate returns through skilled security selection rather than relying on the overall movement of the market. This strategy allows the fund to potentially generate profits in both rising and falling markets, if the relative performance of the selected investments differs from the market.

To achieve market-neutrality, the fund manager might select long and short positions with a focus on certain factors such as valuation, fundamental analysis, and technical indicators. By maintaining a balanced portfolio with offsetting positions, the fund seeks to hedge out systematic risks, including general market fluctuations and macroeconomic factors, while aiming to capture potential returns from individual securities or sectors.

Market-neutral funds often employ quantitative models, statistical arbitrage strategies, or other techniques to identify investment opportunities with favorable risk-reward profiles. These funds typically target consistent, uncorrelated returns and attempt to minimize exposure to market-specific risks.

What is Beta?

A key financial concept to understanding why an investor might use a market-neutral fund is beta. In finance, “beta” is a measure of an investment’s volatility in relation to the overall market. It indicates the sensitivity of an investment’s price movements to changes in the broader market. Beta is a statistical calculation that compares the historical price movements of an investment to a benchmark index.

A beta value of 1 indicates that the investment tends to move in line with the market benchmark. If a beta is less than 1 (e.g., 0.8), it suggests that an investment is generally less volatile than the market. Conversely, a beta greater than 1 (e.g., 1.2) indicates that the investment is typically more volatile than the market.

Many market-neutral funds aim for a low or zero beta. This means, they try to provide returns that have zero correlation to their benchmark. The goal is for a market-neutral fund to balance the returns of the portfolio so that it can reach the efficient frontier. Which is the optimal portfolio balancing risk and return given any set of investment objectives.

Why might investors use market-neutral funds as part of a diversified portfolio?

In the context of Modern Portfolio Theory and the Efficient Frontier, the inclusion of market-neutral funds in a diversified portfolio can be understood as an attempt to achieve better risk-adjusted returns. Modern Portfolio Theory supports the idea that investors can construct an optimal portfolio by combining assets in such a way that they achieve the highest possible expected return for a given level of risk. The Efficient Frontier represents the set of these optimal portfolios.

Market-neutral funds are designed to have a low correlation with the broader market. When an asset or a fund, such as a market-neutral fund, has a low correlation with the existing assets in a portfolio, it can provide diversification benefits. By including market-neutral funds, the overall portfolio’s risk can be reduced without necessarily reducing expected returns. This is because, while the long positions in the market-neutral fund might be correlated with the market, the short positions can offset this, essentially making the fund’s performance more independent of market movements.

By reducing the portfolio’s overall volatility, market-neutral funds help in moving the portfolio closer to the Efficient Frontier. On the Efficient Frontier, for each level of risk, you’re achieving the maximum rate of return. If a market-neutral fund effectively reduces volatility without proportionately reducing expected returns, it helps in optimizing the portfolio’s position relative to the Efficient Frontier.

What are the returns on market-neutral funds?

Unfortunately, the performance of market-neutral funds has been terrible. Sure, they don’t correlate with the benchmark index, but investors would have been better off by simply holding a portion of their portfolio in cash instead of using market-neutral funds. The returns on cash (T-bills, HISAs) have been a lot better than market-neutral funds over most time-periods.

Here are some market-neutral funds for Canadians:

To get an idea of what types of returns investors should expect from market-neutral funds, let’s analyze the returns of the Vanguard Market-neutral Fund since it has the largest size and longest history.

In June 2003, the shares traded at 10.60, and 20 years later they’re at 12.50. This is a difference of 18%. But, if you’d held an S&P 500 Index ETF over the same time-frame, your gains would be 248%. Granted, you’d need to hold on to your stocks during the 2008 financial crash, and during the covid lockdowns. But, if you did, you’d be far better off compared to holding a market neutral fund.

Maybe the most important aspect about market-neutral funds to keep in mind is that they’re a portfolio diversification tool. They aim to smooth out the returns of a portfolio. But, in exchange, investors give up a ton of potential gains. So, if you can psych yourself up for the almost certain chance that the stock market will go up and down then you will be better off holding stocks than almost any other investment (including market-neutral funds) in the long-run.

Why have the returns on market-neutral funds been so poor?

There are three main reasons why the returns of market-neutral funds are poor:

The “Risk Premium”
Active Management
Fees

What is the risk premium?

The term “risk premium” refers to the extra return that an investor expects to earn, or should expect to earn, for taking on additional risk compared to a risk-free investment. Essentially, it is a compensation for bearing the uncertainties and potential downsides associated with riskier investments. So, if you can stomach the extra risk, you will earn a higher reward. Practically speaking, if you can hold onto stocks while other investors are hiding out in cash and other less risky investments, then your portfolio will perform better in the long-run.

Why does active management under-perform passive management?

The lure of most market-neutral funds is they rely on the idea of the benefits of active management. Market-neutral funds presume that an investment manager can choose some long and some short positions that benefit from some fundamental or technical analysis. But, the reality is that most active managers fail to outperform their passive benchmarks.

Active managers under-perform for a few reasons:

Psychology – Investor biases are magnified by active management. Making more decisions allows more emotional bias to creep into decision making. The result is our investor biases are a drag on investment returns.
Fees – Active management generally involves higher costs than passive investing. These costs include not just higher management fees, but also transaction costs, which can be substantial if the manager trades frequently. So, fees become a big drag on returns.
Efficiency – In efficient markets like stocks, prices reflect all available information. Therefore, it’s tough for an active market-neutral manager to find undervalued stocks to buy or overvalued stocks to sell, which makes it difficult to outperform a passive benchmark that simply hold a broad cross-section of stocks.
Taxes – When buying and selling, capital gains taxes are realized. These taxes drag down the returns of market-neutral funds. In contrast, index funds rarely buy or sell. So, they are much more tax efficient.

A little more about fees

When we consider the under-performance of market-neutral funds, fees play a big part. Most active investment managers change less than 0.75% nowadays. Some active managers charge even less. But, the fees for market-neutral funds are usually more than 1%. This big jump in the fees for market-neutral funds is one of the biggest reasons to avoid them. The extra fees simply drag down returns.

Should investors add market-neutral funds to their portfolio?

Instead of adding market-neutral funds to their portfolio, investors should hold a diversified portfolio of simple to manage blue-chip investments like stocks, bonds, and real estate. They should hold these investments in amounts that align with their own investment objectives and risk tolerance. And, forget about trying to “beat the market”.

In addition, most wealthy investors should learn to accept more stock market risk. Since its economically easier to ride the ups and downs of the financial markets with a large portfolio; wealthy investors should hold lots of stocks and then focus on the emotional elements of investing instead. This means, getting advice and support about how to remain invested in a portfolio of stocks for the long-run, especially when markets are bearish. And, not to sell when times look tough (because these might be the best times to buy, not sell).

Wealthier investors should also hold a greater portion of their portfolio in stocks instead of bonds. This is because wealthy investors are better able to capture the “risk premium” inherent in equity returns for the reasons just mentioned. Whereas lower risk investors who buy bonds only get pre-determined rates that do not capture the gains from economic growth.

Is portfolio management bad?

Portfolio management isn’t bad, its just trendy. The theory underpinning modern portfolio theory isn’t wrong per-se. But, in practice it cuts the returns of many investors off at the knees. By attempting to make guesses about which investments may rise and which ones may fall, many investors fall victim to various biases. I’ve never met any investors who became rich by using market-neutral funds (or bonds either).

Legendary investors like Warren Buffett don’t practice portfolio management. Instead, they hold a portfolio of profitable businesses directly (and for the long-run, never selling). They also stay invested during both the ups and the downs of the economy so that in the long-run, they can capture the benefits of technological innovation and economic growth.

Conclusion: The Verdict on Market-Neutral Funds

After delving into the mechanics, objectives, and performance of market-neutral funds, its evident that these funds may serve a purpose for investors seeking to mitigate market risks and add diversification to their portfolios. However, their historical underperformance and high fees suggest that they are a bad way to achieve long-term investment goals. Market-neutral funds also come with their own set of challenges and intricacies that make them unsuitable for most investors.

For the average investor, especially those with long-term time horizons, the traditional approach of holding a diversified basket of high-quality stocks remains the most productive strategy. This approach aligns with capturing the long-term economic gains and the “risk premium” associated with equities. Moreover, avoiding the high fees and the active management pitfalls of market-neutral funds can result in a more favorable outcome in the long run. And, provide investors with greater peace of mind over time since buying-and-holding is a simple strategy to follow.

For those who are already wealthy and can withstand most “market gyrations”, embracing a higher equity allocation and focusing on the psychological aspects of investing may prove to be more beneficial. This is because doing so allows investors to participate more directly in the economic growth and technological advancements that historically have rewarded equity holders.

In conclusion, while market-neutral funds can be a niche component for certain investors seeking uncorrelated returns and lower portfolio volatility, they should be approached with caution and a deep understanding of their intricacies. For the majority, a simple, well-diversified investment strategy that includes stocks, bonds, and real estate, coupled with a long-term perspective and disciplined approach, will be more conducive to achieving financial goals.

Is a Market-Neutral Fund a Good Investment?