When the stock market declines, financial advisors will usually caution investors to focus on a long-term strategy and ignore the market's ups and downs. But that is easier said than done, and investors who are losing valuable sleep over the market's roller-coaster ride may want to consider adding another component to their portfolio: market-neutral funds. (Be sure to read Long-Term Investing: Hot Or Not? to learn more about this investment strategy.)

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.

Diversification Potential
In financial terminology, market-neutral funds are designed to provide significant alpha, but little or no beta. Beta is the correlation of an investment with a broad stock market index such as the S&P 500, 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 his/her 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 his funds into a market-neutral fund with a beta of 0 and a predicted alpha of 5.0. His 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 he 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. (Learn how to properly use this measure to meet your risk criteria in our related article Beta: Gauging Price Fluctuations.)

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. (To learn more about investing with advanced concepts such as these, read Can You Invest Like A Hedge Fund?)

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. (Read more about choosing a portfolio manager in Choose A Fund With A Winning Manager.)

Transactions And Expenses
As a rule, market-neutral funds will have higher management fees (2% to 3%) 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. (Read more about the costs associated with these and other funds in Mutual Funds: The Costs.)

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. (Learn how to lower costs on your mutual funds in Stop Paying High Mutual Fund Fees.)

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. (Read more about the cost of capital in Investors Need A Good WACC.)

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. (Learn how to decipher this important document in Digging Deeper: The Mutual Fund Prospectus.)

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. (Read more about this investment strategy in Enhance Your Portfolio With Active Equity.)

130/30 ETFs are expected to arrive in the marketplace at some point. While market-neutral funds also could be offered as low-cost ETFs, at the time of this writing there are no specific products available to retail investors.

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. (Read more in Data Mining For Investing.)

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 broad 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 Jagadeesh and Titman and now widely accepted, is momentum, the tendency of stock prices to continue moving in the same direction. (Read more about these ideas in Investigating The Stock Premium Puzzle and Riding The Momentum Investing Wave.)

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 management and 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. There are times that investors will sell anything and everything in order to raise cash, regardless of fundamentals. (Learn to use fundamentals to your advantage in Fundamental Analysis For Traders.)

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.

For related reading, check out The Rise Of The Hedged Mutual Fund.

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