A market-neutral fund is a type of investment vehicle, often found in hedge funds, that aims to generate profits regardless of whether the overall market is trending upward or downward. These funds utilize a strategy that involves taking paired long and short positions or employing derivatives. The goal is to create a balanced portfolio that is agnostic to price movements, allowing the fund to potentially earn positive returns in various market conditions. Market-neutral funds can be seen as a means of mitigating market risk and seeking alpha, which refers to additional returns beyond the market return through active trading.
Understanding Market-Neutral Funds
Market-neutral funds are designed to provide returns that are independent of the performance of the overall stock market. The key characteristic of these funds is the focus on generating alpha while minimizing or eliminating exposure to beta. Beta represents the correlation of an investment with a broad stock market index, such as the S&P 500. Alpha, on the other hand, refers to the excess return achieved through active trading.
It is important to note that the inclusion of market-neutral funds in an investor's portfolio does not guarantee outperforming the market. These funds are more complex than traditional mutual funds, and the associated expenses can be high. However, they have the potential to enhance returns and reduce risk.
Market-Neutral Fund Strategies
Market-neutral fund strategies involve taking simultaneous long and short positions. These strategies differ from traditional long/short funds as they typically employ arbitrage techniques to profit from paired trading positions. Market-neutral funds often employ either qualitative or statistical correlation approaches. Equity market-neutral (EMN) funds focus specifically on trading stocks.
Qualitative strategies in market-neutral funds involve identifying securities or market products that present potential arbitrage convergence opportunities. The portfolio manager selects pairs of securities and executes trades based on the expectation of price convergence.
Statistical correlation strategies, on the other hand, capitalize on deviations from historical correlations. These strategies involve identifying highly correlated stocks and taking long positions on underperforming stocks while shorting overperforming stocks. The aim is to benefit from the correction in correlation, which is expected to return to its historical level.
Investing in Market-Neutral Funds
Market-neutral strategies are primarily available through hedge fund managers, who offer them in hedge fund structures or registered product structures. Due to their complexity and high risks, market-neutral funds are not suitable for all types of investors and are typically not used as core holdings in portfolios. These funds often have higher fees and turnover, which should be considered by investors.
Examples of Market-Neutral Funds
Two examples of market-neutral funds are the AQR Equity Market-Neutral Fund and the Vanguard Market Neutral Investor Fund. The AQR fund uses qualitative and quantitative analysis to identify attractive pair trade opportunities and has generated positive returns in the past. The Vanguard fund employs long and short-selling strategies to minimize the impact of the stock market on its returns.
Summary
Market neutral funds might be hedge funds or mutual funds or ETFs whose strategy is not based on bullish or bearish market predictions but instead seeks to be in a position to profit whether the market goes up or down.
Most mutual funds and ETFs out there are inherently bullish — you invest in those funds because you believe or hope that the industry or geographic region or cap-size that they invest in will grow in the future. Some funds offer bears a place to hole-up when the bubble inevitably bursts (or so they think).
Market neutral funds avoid making bets in either direction and instead seek to profit whether the market goes up or down. They do this by using long and short positions that basically balance one another out, but can also use derivative instruments and leverage. This strategy may limit returns, but it can also minimize risks. The strategy generally only seeks returns a few percentage points above the risk-free Treasury rate.
Equity-neutral hedge funds were shown by some research to have the lowest correlation to other hedge funds; they pick certain stocks to go long on in a category, at the discretion of the fund manager and mix their other long/short positions in the category to remain neutrally positioned for overall movement in the category.
Because these will all be uniquely blended according to the beliefs of their fund manager, they are basically market-neutral alternative investments.