Market-neutral strategies seek to help diversify portfolio risk, and to find profit regardless of economic, interest rate, sector, stock, or bond market performance.
“The goal of almost every market-neutral fund is to arbitrage market mispricing by been on the convergence of spreads, or the difference between a long and a short position pair,“ according to Morningstar. “As the long positions increases in value and the short position declines in value.”
How should alternative investment managers talk with potential investors – in your pitch books, on your website, in email campaigns, and other content marketing – about the market-neutral category? Consider these five bullets:
1. Market-Neutral Funds Have Historically Low Correlation to the S&P 500
Your first talking point should emphasize the categories’ low correlation to the S&P 500 Index. The correlation of the S&P 500 to the Morningstar Market Neutral category was 0.06% for the five years ended June 30, 2014. The closer the correlation is to 1, the more a security moves in lockstep with the S&P 500.
2. Market-Neutral Funds Have Outperformed the S&P 500
While past performance cannot predict future results (where have we heard that before?) during the five years ended August 30, 2014, market-neutral funds outperformed the unmanaged S&P 500 Index. The average market-neutral equity fund returned 2.92% in 2013 and 0.18% in 2013, versus 0.07% and 0.05% for cash, as represented by 3-month U.S. Treasuries, over the respective time periods. Only nine of the 42 market-neutral funds had a 10-year track record.
3. Historically Lower Volatility Than A Long-Only Strategy
One of the main advantages of market-neutral investing is a greater emphasis on hedging against market volatility. The closer the correlation is to 1, the more a security moves in lockstep with the S&P 500. While past is not prologue, market-neutral investing has historically provided little correlation vs. major stock and bond categories. The data below is as of June 30, 2014 for the Morningstar Market-Neutral category vs. stocks and bonds.
4. Pairs Trading: The Long and Short of It
Pairs trading typically involve trading two highly correlated assets. The paired assets can be, among others, stocks, indexes, ETFs, bonds, and currencies.
For example, the stocks of Coke and Pepsi (YUM Brands) are in the same industry, typically move together in price, and have a high correlation. Pairs traders look for deviations, and attempt to exploit them. If Coke moves higher as Pepsi declines, a trader may take a short position in Pepsi and a long position in Coke. Some sample pairs:
5. Investors Are Not Neutral About Investing In Market-Neutral Funds
In fact, it’s a relative large category: investors held $43.3 billion in the market-neutral category as of December 31, 2014, according to BarclayHedge, an increase of nearly $5 billion from the previous six months.
Hedge Funds: For Accredited Investors Only
Market-neutral strategies are used in both hedge funds and mutual funds, but only accredited investors may invest in hedge funds. An accredited investor is an individual with a net worth, or joint net worth with the person’s spouse, that exceeds $1 million (excluding primary residence) at the /me of the purchase, or an individual income in excess of $250,000, or in excess of $300,000 with his or her spouse, in each of the two most recent years, and who has a reasonable expectation of an income in excess of $250,000 individually, or in excess of $300,000 with his or her spouse in the current year.
Pairs trading does not provide a hedge for a specific stock. Execution may be adversely affected by market disruption, including broad market declines, among other factors. The risk of loss is increased by the use of margin, which is necessary to maintain the short position. The S&P 500 Index is an unmanaged market-weighted index of leading companies and industries, dominated by large- capitalization firms. The Barclays U.S. Aggregate Bond Index is a broad-based benchmark that measures the investment grade, US dollar- denominated, fixed-rate taxable bond market. While market-neutral funds may mitigate against downturns, they also have limited upside in a bull market.