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.