Shelter From The Volatility Storm?

1 An annual income of $200,000 for the past two years with a reasonable expectation of maintaining that income level in the future, or

2 A household income of $300,000 per year, or

3 A net worth of $1 million, excluding home and automobile.

FIGURE 1: CUMULATIVE ASSET FLOWS. Inflow of assets into hedge funds has been increasing since 1994.

MARKET-NEUTRAL FUNDS

Market-neutral funds allocate half their portfolio to long positions and the other half to short positions. The managers of market-neutral funds will invest in undervalued stocks in the hope the funds will go up, and short stocks that are overvalued in the hope they will go down. This suggests that during a bull market, the long positions will do well, and during a bear market, the short positions will outperform. Sounds like a great strategy that can't go wrong, doesn't it? The value of your portfolio goes up whether the markets go up or down, and the portion of your portfolio that is in cash will be invested in money market instruments. If worst comes to worst, you'll at least gain a modest return, if nothing else.

Unfortunately, market-neutral funds haven't lived up to expectations. They were intended to be a shelter from market volatility, but let's face it -- anyone who has tried picking stocks on his or her own knows too well that you have to pick the right stocks. There are only a handful of market-neutral funds available, and only a small percentage of those have performed better than the S&P 500. The Rosenberg Value Market Neutral fund (BRMIX) had a three-year average tax-adjusted return of -10.10%. Out of the six market-neutral funds (Figure 2), only two have outperformed the S&P 500, with only the Montgomery Global Long Short fund displaying impressive returns. Even so, during 2000 when the Vanguard 500 Index fund was down -9.1%, this fund was down -25%. For a fund that is supposed to protect an investor during a declining market, it certainly didn't deliver. Theoretically, market-neutral funds do have the potential to outperform the market, but that depends on the individual strategies employed by the specific fund, just as with any other mutual fund.

FIGURE 2: PERFORMANCE. Returns from market-neutral funds compared to the Vanguard 500 Index fund (VFINX).

CONCLUSION

Although market-neutral funds were introduced to reduce the risks associated with investing, their performance has proved otherwise. This, together with higher expenses and turnover, makes them an unattractive investment. If given the choice, I would stay away from them.

Editor Jayanthi Gopalakrishnan can be reached at Jayanthi@Traders.com.