Market-Neutral Fund Returns Are Hard to Find

by Daniel Putnam | July 21, 2011 10:23 am

Market-Neutral Fund Returns Are Hard to Find

The fast-growing category of market-neutral funds has been a cash cow in recent years. Unfortunately, the bulk of the cash has been flowing to the mutual fund companies rather than their investors.

Market-neutral funds typically invest about the same amount of money on both the long and short sides of the market. In theory, the dollar value of the long positions should rise more than the value of the short positions declines (or vice versa), meaning that the manager’s stock selection should generate a positive net return for investors. These funds are typically sold as fixed-income alternatives or diversification vehicles that provide individuals with access to a strategy that in the past was only available through hedge funds. At least, that’s what the marketing material tells us.

The problem is the funds haven’t produced any returns. The table below shows that market-neutral funds are essentially flat over all time periods, and have underperformed the traditional asset classes by a wide margin:

 

YTD Return (%)

1 Year Return (%)

3 Year Avg. Annual Return (%)

5 Year Avg. Annual Return (%)

  Lipper Equity Market Neutral Funds Average

1.44

3.70

(0.29)

0.92

  S&P 500

6.02

30.69

3.34

10.35

  Barclays Aggregate U.S. Bond Index

4.38

10.51

6.04

19.24

 

It should also be noted that as a group, the category has saddled investors with negative inflation-adjusted returns in the three- and five-year periods.

A look at where the market-neutral funds category stacks up against other types of funds paints a similarly bleak picture. Morningstar separates all equity, bond and alternative funds into 85 groups. During the past three and five years, the market-neutral category has finished 73rd and 80th, respectively. The three- and five-year intervals each incorporate both bull and bear markets, so the weak showing of market-neutral funds can’t be written off to an unusual environment in any one period.

Part of the problem, of course, is fees. Most funds in the neutral category have fees in the 1.75% to 2.5% range, with some ranging north of 3%. Keep in mind, the average long-only mutual fund tends to underperform the broader market over time. For a market-neutral funds to be successful, these same companies not only need to have their longs outperform, but also their shorts – and to a large enough extent to generate meaningful returns above the fees. There appears to be a low likelihood of this scenario playing out in a favorable way.

Market-neutral funds are typically presented as a new way for investors to achieve portfolio diversification, since market-neutral strategies tend to have low correlations with stocks and bonds. But with the evidence showing that market-neutral funds are essentially dead money, it seems that investors could achieve a better risk/reward trade-off in a short-term bond fund.

The bottom line: Fund companies are facing stiff competition from exchange-traded funds. Domestic ETFs’ total assets have grown to about 13.8% of mutual fund assets – still a low percentage on an absolute basis, but one that is rising quickly. Predictably, the mutual fund companies are responding with an array of exotic products to help them maintain their market share. Investors should therefore be acutely aware of the difference between ideas that sound good in the marketing brochures, and those that actually can generate meaningful returns over time.

 

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