But inconsistent past performance means advisors must proceed with caution.

    If you want to invest clients' assets in market-neutral mutual funds, scrutinize their performance. Market-neutral and long/short mutual funds are designed to deliver absolute returns independent of the performance of the overall stock market. The funds typically achieve this by shorting overvalued stocks and taking long positions in undervalued stocks. In theory, adding a market-neutral fund may act as a good portfolio diversifier. Market-neutral funds have low correlations to the stock market.
    The big problem: They are not all alike. Some funds sport low correlations to the S&P 500, and have delivered consistent returns over the past three and five years. Other funds, at times, may be highly leveraged, and make big bets-either by making long or short sales or by sector. As a result, these funds can register equity-like gains or losses.
    The 1997 tax law changes opened the door for mutual funds to engage in market-neutral investing. Previously, mutual funds could not obtain more than 30% of their income from short-term capital gains-gains on securities held less than three months. Gains from short sales are considered short term.
    Today, there are more than 17 open-end type hedge funds, which go by the rubrics of "Market Neutral" or "Long/Short" mutual funds, according to Morningstar Inc. in Chicago. Over the past five years, several funds have done their jobs during a sluggish stock market. 
    Financial research shows that adding the right market-neutral fund to a portfolio of stock and bond funds can improve risk-adjusted rates of return. A study by Dulari Pancholi, a research associate at the Isenberg School of Management at the University of Massachusetts, Amherst, found that, on average, market-neutral funds improved a portfolio's risk and return relationship.
    For example, from January 1998 though December 2003, a portfolio containing stock, bonds and market-neutral funds registered a 7.9% annual return with a standard deviation of less than 9%.By contrast, a 100% stock and bond portfolio had an 8% annual return, with a standard deviation of 10%. "Hybrid mutual funds provide small investors a unique risk-return opportunity not usually provided by most traditional investment vehicles," the study said.
    But you can't hang you hat on that study, entitled The Benefits of Hybrid Mutual Funds, and published by the University's  Center for International Securities and Derivatives Markets. The results are based on five hybrid mutual funds over just a five-year period. Plus, the study showed that some market-neutral funds tracked the S&P 500 on both the upside and downside.
    Stock picking ability is an important variable in the success of a market-neutral fund, the study warns. Taking long and short positions magnifies a portfolio manager's decisions. "This (market-neutral investing strategies) also empowers the managers with the flexibility of engaging in dynamic investment strategies," the study said. "This may increase the risk of the investment."
    Barry James, president of the James Market Neutral Fund, says investors are putting about 10% to 20% of their stock portfolios into his fund. And since its inception in October 1998, the fund has grown at a 4.22% annual rate by taking a market- and sector-neutral stance. James' fund invests long in stocks that have low price-to-earnings ratios and price-to-book values. On the upside, the companies must show good earnings and strong relative strength. When the stock market declines, James shorts overpriced stocks with poor earnings and relative strength. The fund does not use leverage, and typically has about equal long and short positions.
    Steven Dean, director of Global Product Strategy with AXA Advisors, subadvisor to the Laudus Rosenberg funds, says financial advisors are putting about 10% of client assets in Laudus' three market-neutral funds. They invest in either value, mid-cap or global stocks for diversification.
    "Often advisors will use multiple market-neutral funds to diversify manager risk for an absolute return strategy," he said.
    Despite the potential benefits of market-neutral funds, some financial advisors don't like them.
    Richard A. Ferri, CFA, author of All About Asset Allocation (McGraw Hill), avoids these funds for several reasons:
    It is difficult to find benchmarks to evaluate market-neutral fund performance. 
    Fund expenses are too high. They sport annual expenses ranging from 2% to more than 3%.
    Market-neutral fund returns are inconsistent. They performed poorly during the bull market of the 1990s, and there are big differences in their year-to-year returns. market-neutral
    A mix of stocks, bonds and cash can deliver sufficient risk-adjusted rates of return.
    "They  do not generate enough alpha," says Ferri, a Troy, Mich.-based investment advisor with $500 million in assets under management. "It is a leap of faith to rely on a portfolio manager to long and short stocks. And the expenses are too high."
    Ferri suggests that accredited investors who insist on a portfolio diversifier should consider hedge funds rather than open-end long/short mutual funds, because hedge funds have more investment flexibility and fewer investment restrictions.
    One big problem financial advisors face in picking a market-neutral fund is that in the past they failed to deliver the promised steady returns, according to Morningstar data. For example, Laudus Rosenberg Value Long/Short Equity Fund lost -15.7% during the bull market of 1998 through 2000. From 2001 through 2004, the fund gained 35.9%.
    Dean, of AXA Advisors, says the performance of the Laudus Rosenberg Value Long/Short Equity Fund during the late 1990s was more volatile than the expected because of the performance of specific stocks, rather than the direction of the market. Overvalued companies with poor earnings were leading the market, while the fund was long in undervalued stocks with good expected earnings. It was only when the high-priced companies with weak earnings declined that the fund began to perform well on the short side. As a result, during the sluggish market over the past three and five years, its stable of long/short funds outperformed the S&P 500.
    "In the late 1990s, the kinds of stocks that were leading the market were the most expensive stocks delivering the worst earnings," he said. "In this type of environment, our long positions were underperforming our short positions. That is exactly the opposite of what a long/short fund market-neutral manager is trying to accomplish."
    The Laudus Rosenberg long/short fund weathered the storm. However, a number of funds did so poorly in the late 1990s and early 2000s that they shut down. The following market-neutral funds, according to Morningstar, either merged or were liquidated: The Montgomery Global Long/Short Fund, Crabbe Huson Special, Heartland Small Cap Contrarian, Dreyfus Premier Market Neutral, Puget Sound Market Neutral, Lindner Market Neutral Fund and Legg Mason Market Neutral.
    Morningstar data also show that market-neutral fund returns are not as independent of the stock market as many expect. For example, the average R squared of the market-neutral funds was 35%. The R square is a measure that shows that 35% of the volatility of market-neutral funds is determined by the volatility in the S&P 500. An R square of 35% translates into 59% correlation with the S&P 500.
    Russel Kinnel, Morningstar director of research, says most funds use investment strategies that have a built-in bias to stocks with low price-to-earnings multiples and revenue growth. Most market-neutral funds typically are sector neutral. But stock bias affects their market neutrality.
    "Long/short funds are not market neutral," he says. "People don't need these funds. The best market-neutral funds are closed to new investors and the rest are mediocre and high-cost."
    The ability of market-neutral funds to deliver absolute returns may be questionable. But they have delivered the goods during the soft stock market, when the S&P 500 grew at annual rates of 4.6% and -1%, respectively, over the three- and five-year periods ending in February 2005.
    Market-neutral funds that have outperformed the S&P 500 with less risk over the past three-year and/or five-year periods include: The James Market Neutral Fund, all three of The Laudus Rosenberg market-neutral funds and the Phoenix Market Neutral Fund (see table).
    Unfortunately, the funds with the best longer-term track records are closed to new investors. Nevertheless, their performance is worth noting in case they reopen.
    The Robeco Boston Partners Long/Short Fund has grown at 3.15% and 17.35% annual rates over the past three-year and five-year periods, respectively. But the fund lost -14% in 1999.
    The Calamos Market Neutral Fund has delivered some of the best and most consistent returns in its class. Over the 10 years ending in February 2005, the fund grew at an annual rate of 9.60%. Unlike its peers, the fund buys convertible bonds and shorts the underlying stock.
    John Calamos, the fund's manager, invests keeps at least 65% of assets in investment grade convertible bonds. He sticks with companies that exhibit strong cash flow, revenue growth and return on capital. The fund sports a beta value of just .56, but it has performed in line with the S&P 500 for the past ten years, according to Morningstar. Some of the funds largest preferred holdings include Tyco, Albertson's, Washington Mutual and Morgan Stanley.