Getting Positive Results With Market-Neutral Funds (2024)

When the stock market declines, financial advisors will usually caution investors to focus on a long-term strategy and ignore the ups and downs. But that is easier said than done, and investors who lose sleep over the market's roller-coaster ride may want to consider adding another component to their portfolio: market-neutral funds.

Market-neutral funds are designed to provide returns that are unrelated to those of the overall stock market. The addition of these funds to an investor's portfolio has the potential to boost returns and reduce risk, but the funds are much more complex than traditional mutual funds, and the expenses can be high. In this article we will discuss why they may or may not be a good fit for your portfolio.

Key Takeaways

  • Market-neutral funds are designed to provide significant returns that are uncorrelated with a broad stock market index such as the S&P 500 Index.
  • A market-neutral fund will typically deliver returns by combininglongandshortpositions in various securities.
  • Because of higher portfolio turnover, fees and expenses for market-neutral funds are often higher than index funds and actively managed equity funds.
  • Because market-neutral funds create their own proprietary investment strategies, it can be very difficult to identify the market factors that will impact their performance.

Diversification Potential

Market-neutral funds are designed to provide significant alphabut little or no beta. Beta is the correlation of an investment with a broad stock index such as the , and alpha is the additional return beyond the market return.

However, this doesn't necessarily mean that a market-neutral fund will beat the market or that an investor would be better off having a market-neutral fund in their portfolio. Consider the following situation:

An investor has a portfolio with a beta of 1.0 and an alpha of 0—equivalent to a broad stock or index fund. This investor decides to move half of their funds into a market-neutral fund with a beta of 0 and a predicted alpha of 5.0. Their portfolio now has an alpha of 2.5 and a beta of 0.5, calculated by averaging the two investments.

If the index delivers high returns, the investor may regret the reallocation and wish that they had more beta in the portfolio to help capture that performance. But if the index performs poorly, then the investor may receive a significant boost from owning the market-neutral fund.

In this example the alpha is constant, but in practice, the alpha (and perhaps even the beta) of the market-neutral fund would fluctuate, due to risk in the underlying investment strategy. This variation may help or hurt the portfolio in any period, and should be considered another source of risk.

How They Work

There are many ways to generate investment returns, and every fund has some unique elements, but typically a market-neutral fund will deliver returns by combining long and short positions in various securities. The simplest and most conventional example would be a long-short stock fund, but bonds, currencies, commodities, and derivatives could be used as well.

In a long-short stock fund, an investment manager ranks a population of stocks by a combination of factors that could include both quantitative and technical factors such as value, momentum, liquidity, sentiment, and also analyst opinions. Then two portfolios are constructed:a long portfolio with the stocks that are expected to outperform the market and a short portfolio with the stocks that are expected to underperform.

The market-neutral fund would then maintain a near-identical amount of long exposure and short exposure in order to build a portfolio with near-zero market exposure. This will require some ongoing adjustments, as the values of the long and short positions will change over time due to price fluctuations.

As an example, if a fund has $1 million of both long exposure and short exposure, and if the value of the stocks in the long portfolio climbs 10% and the value of the stocks in the short portfolio falls 10%, then the fund will then have $1.1 million of long exposure and $900,000 of short exposure. With more long exposure than short exposure, the fund would now no longer be market-neutral.

To address the imbalance, the portfolio manager could either increase the short position or reduce the long position. The portfolio manager could also choose to match the long exposure and the short exposure with the amount of equity in the portfolio, so as the amount of assets under management increases or decreases, the sizes of the corresponding long and short portfolios do the same.

Transactions and Expenses

Typically, market-neutral funds will have higher management fees than either index funds or actively managed equity funds. This is likely the result of both fund complexity and supply and demand—managing a market-neutral fund is seen as more complex than managing a passively or actively managed stock fund, and the corresponding alpha is more desirable.

An argument can be made that market-neutral funds are not designed to compete with these conventional funds at all, and are best compared to hedge funds. From that perspective, the management fees charged by a market-neutral fund would be relatively low in comparison.

All funds have transaction expenses that effectively reduce investor returns. However, the transaction costs associated with a market-neutral fund may be significantly higher than those of other funds due to rebalancing strategies and higher portfolio turnover. Many market-neutral funds have very dynamic trading strategies in which stocks are held only for months or even weeks, and portfolio turnover can be 1,000% or more.

Short positions may also incur additional expenses arising from the costs of borrowing securities or other costs of capital. For example, in order to hold the $1 million short position described above, the portfolio manager will have to maintain some type of collateral, and holding this collateral may require that the long stock position be held on margin and incur interest costs. Short stock positions would also require that the portfolio pay any dividends associated with those stocks.

These expenses can be found in the fund prospectus, but they are not always obvious. While management fees are almost always clearly stated in percentage terms, there may be fee adjustments that make it difficult to determine whether the expense level will rise or fall in the future. Other fees, such as transaction costs, may have to be determined from analyzing the fund income and expenses.

Market-neutral funds are often compared to 130/30 funds. In these funds, the portfolio manager holds a long position equal to 130% of assets and a short position equal to 30%. These funds would be expected to have a market beta, but potentially more alpha than a typical 100% long-only fund, as they provide more opportunities for a manager to exercise stock selection abilities.

Do They Deliver?

The fundamental premise underlying market-neutral funds (that it is possible to predict which stocks in a market will either outperform or underperform the market as a whole) may be difficult to digest for the die-hard index investors who believe that active selection can never beat the aggregate performance of the market. But for more than four decades, researchers have been mining the market's data to better predict performance.

Market capitalization and book-to-market ratio (also known as size and value/growth) are two well-known factors that can help identify whether a stock is likely to outperform or underperform the broader market. These factors are attributed to Eugene Fama and Ken French and are sometimes known as the Fama-French factors. A third factor, identified by Narasimhan Jegadeesh and Sheridan Titmanand now widely accepted, is momentum, the tendency of stock prices to continue moving in the same direction.

As these and other factors are identified, funds can be constructed specifically to capture the market premium by holding long positions in stocks with the specific factor and short positions in other stocks that lack it. Still, each factor will have its own average return and volatility, either of which could vary at any time due to market conditions, and as a consequence, overall fund returns may be zero or negative for any period.

Because each market-neutral fund creates its own proprietary investment strategy, it can be very difficult to identify exactly which factors the fund is exposed to. This makes performance analysis, risk managementand portfolio construction challenging. In the trading and hedge fund space, proprietary strategies like this are sometimes referred to as "black boxes" due to the lack of transparency.

It can also be difficult to predict how a market-neutral fund will behave in a market crash. If a fund has shown a low correlation to the index in a bull market, that doesn't necessarily mean that it won't fall during a bear market. There are times that investors will sell anything and everything in order to raise cash, regardless of fundamentals.

The Bottom Line

While market-neutral funds have the potential to provide diversified returns and improve portfolio performance, individual fund performance is largely the result of the fund's design and construction and the portfolio manager's skill. This means that it is critical for investors to carefully read prospectuses and analyze past performance in a variety of conditions in order to determine whether the fund's management, in fact, delivers on its promise.

Getting Positive Results With Market-Neutral Funds (2024)

FAQs

What is the point of a market-neutral fund? ›

What Is Market Neutral? A market-neutral strategy is a type of investment strategy undertaken by an investor or an investment manager that seeks to profit from both increasing and decreasing prices in one or more markets while attempting to completely avoid some specific form of market risk.

What is the best strategy for a neutral market? ›

Popular examples of neutral options strategies include ratio spreads, calendar spreads, covered call/put, and short straddle. For instance, in a cover call strategy, traders own a stock and sell call options against it. Additionally, a covered put involves selling put options while shorting the stock simultaneously.

What is an example of a market-neutral strategy? ›

A common example of a market-neutral fund strategy is “pair trading”. For instance, suppose a market neutral hedge fund pairs investments in Alphabet (NASDAQ: GOOGL) and Microsoft (NASDAQ: MSFT).

Would a market-neutral hedge fund be a good candidate for an investor's entire retirement portfolio? ›

No, a market-neutral hedge fund would not be a good candidate for an investor's entire retirement portfolio because such a fund is not a diversified portfolio. The term market-neutral refers to a portfolio position with respect to a specified market inefficiency.

Should I move my money to a money market fund? ›

“If you actually need the money to pay your bills or even if you need the money within the next one or two years, that's when money market funds would be an appropriate investment to use as an alternative to keeping your money at a local bank or a savings account.”

Should I buy a neutral stock? ›

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.

What is the simplest most profitable trading strategy? ›

One of the simplest and most widely known fundamental strategies is value investing. This strategy involves identifying undervalued assets based on their intrinsic value and holding onto them until the market recognizes their true worth.

How to build a market-neutral portfolio? ›

The Equity Market Neutral Landscape

EMN works by taking long positions in stocks that are expected to outperform their peers and short positions in stocks expected to underperform. The positions are chosen so that the equity market exposure of the long side of the portfolio is offset by the exposure of the short side.

What is the least profitable entry strategy? ›

Licensing/Franchising

This method does contain some risks. It's typically the least profitable method for entering a foreign market, and it entails a long-term commitment.

What is the difference between market neutral and pairs trading? ›

Trading strategies which are independent of market move- ments are said to be market neutral. Pairs trading is a mean-reverting strategy, assuming that prices will revert to historical trends. Pairs trading is largely self-funding, since the short sale returns can be used to buy the long position.

How to identify a neutral market? ›

Recognizing a neutral market requires meticulous analysis of market trends, correlations, and volatility. Market Neutral is an investment strategy where an investor seeks to negate market risk or volatility by taking long and short positions in various stocks to increase return on investment.

What does neutral mean in investing? ›

Neutral is an agnostic position in terms of price movements and so is neither bullish nor bearish. Sideways markets or other neutral trends can be taken advantage of through neutral trading strategies.

What is the best portfolio allocation for retirement? ›

At age 60–69, consider a moderate portfolio (60% stock, 35% bonds, 5% cash/cash investments); 70–79, moderately conservative (40% stock, 50% bonds, 10% cash/cash investments); 80 and above, conservative (20% stock, 50% bonds, 30% cash/cash investments).

What is the most conservative type of investment? ›

Conservative investing prioritizes preserving the purchasing power of one's capital with the least amount of risk. Conservative investment strategies will typically include a relatively high weighting to low-risk securities such as Treasuries and other high-quality bonds, money markets, and cash equivalents.

Which portfolio would hold the lowest risk for an investor? ›

Cash. Cash and cash equivalents are the lowest risk, most liquid asset class, meaning that these assets can be easily accessed and are designed not to incur any significant losses. Examples of cash and cash equivalents include savings accounts, money market funds, and CDs (certificates of deposit).

What is the advantage of neutral pricing? ›

The major benefit of a neutral pricing strategy is that it works in all four periods in the lifecycle. The major drawback is that your company is not maximizing its profits by basing price only on the market.

Why would a company want to be cash neutral? ›

Cash Neutral As a Corporate Goal

If there are no investments within the business that can be made to accelerate growth, then investors generally want to see that cash returned to them rather than invested poorly. As a company grows larger, the ability to accelerate growth through acquisition or investment fades.

How do you run a market-neutral portfolio? ›

The Equity Market Neutral Landscape

EMN works by taking long positions in stocks that are expected to outperform their peers and short positions in stocks expected to underperform. The positions are chosen so that the equity market exposure of the long side of the portfolio is offset by the exposure of the short side.

What is the difference between market-neutral and pairs trading? ›

Trading strategies which are independent of market move- ments are said to be market neutral. Pairs trading is a mean-reverting strategy, assuming that prices will revert to historical trends. Pairs trading is largely self-funding, since the short sale returns can be used to buy the long position.

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