What is a Market Neutral Fund

A market neutral fund is a fund that seeks a profit in upward or downward trending environments, typically through the use of paired long and short positions. These funds can potentially serve to mitigate market risk as they seek to generate positive returns in all market environments.

BREAKING DOWN Market Neutral Fund

Market neutral funds can be high risk since their investment strategies rely on the use of leverage, short selling and arbitrage to achieve the desired outcomes. Expected returns can range broadly for these funds depending on the tactics deployed. They are often seen as a potential option for mitigating risk in downward trending markets since they generally offer returns that beat money market holdings. However, some fund managers have historically had greater success achieving returns of benchmark indexes such as the S&P 500.

Market Neutral Fund Strategies

Market neutral fund strategies take long and short positions, however they are distinctly different from long/short funds. Market neutral funds typically use arbitrage strategies that profit from paired trading positions. These funds can generally use either a qualitative approach or a statistical correlation approach. They aim to be market neutral and typically focus on equities because of the available transactional opportunities. Market neutral strategies tend to have profits that are uncorrelated with market movements, meaning their profits are generated based primarily on price movements of the stocks involved.

Qualitative strategies involve paired trades between two securities or market products identified by the portfolio manager as having a potential arbitrage convergence opportunity. Statistical correlation strategies involve paired trades that specifically exploit deviations from a high historical correlation for convergence arbitrage. These strategies use long and short pairs trade investing to achieve capital gains.

Pairs trading requires closely followed technical analysis. After identifying securities with possible market neutral arbitrage profit potential, investors seek to take timely long and short positions which are expected to benefit from price convergence.

In the case of statistical correlation pairs trading, an investor will first identify two highly correlated stocks. Correlations of 0.80 or higher are typically the most prevalent. Following the correlations of the stock pairs through technical analysis, an investor will then seek to take a long position on the underperforming stock and a short position on the overperforming stock when the correlation deviates from its historical norm. The pairs trade seeks to profit from the correlation correction which is expected to return to its historical level of 0.80 or more. If successful the price convergence results in gains from both the long position and the short position.

Investing in Market Neutral Funds

Market neutral strategies are most often available from hedge fund managers, who may offer the management style in a hedge fund structure or a registered product structure. Since market neutral funds are fairly complex products with high risks, they are not suited for all types of investors and generally are not used as core holdings. These funds also tend to have fairly high fees as well as turnover, which can be investor considerations.

AQR Equity Market Neutral Fund

AQR provides one example with its Equity Market Neutral Fund. The Fund is benchmarked to the Bank of America Merrill Lynch 3-Month Treasury Bill Index. It uses qualitative and quantitative analysis to identify conditionally attractive pairs trade opportunities. In 2017, the Fund generated a return of 5.84% versus 0.85% for the benchmark. The Fund has a management fee of 1.10% with gross expenses of 2.24%.