What Is a Market-Neutral Fund?
A market-neutral fund is a hedge fund that seeks a profit regardless of an upward or downward market environment, typically through the use of paired long and short positions or derivatives. These funds can potentially serve to mitigate market risk as they seek to generate positive returns in all market environments.
- A market-neutral fund describes a hedge fund strategy that seeks to earn above-average returns regardless of prevailing market conditions.
- Being market-neutral, the fund takes offsetting long and short positions so that it has a zero delta, or zero beta position and is agnostic to price moves up or down.
- While market-neutral funds can return alpha, these strategies tend to be complex and highly leveraged, increasing both risk and costs to investors.
Understanding Market-Neutral Funds
Market-neutral funds are designed to provide returns that are unrelated to those of the overall stock market. In financial terminology, market-neutral funds are designed to provide significant alpha, but little or no beta. Beta is the correlation of an investment with a broad stock market index such as the S&P 500, and alpha is the additional return beyond the market return earned through active trading.
However, this doesn't necessarily mean that a market-neutral fund will beat the market or that an investor would be better off having a market-neutral fund in their portfolio. The addition of these funds to an investor's portfolio has the potential to boost returns and reduce risk, but these funds are much more complex than traditional mutual funds, and the expenses can be high.
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 simultaneous 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. There are several variations of market-neutral funds, with equity market-neutral (EMN), for instance, specializing in only trading stocks.
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.
Example: AQR Equity Market-Neutral Fund
AQR is a hedge fund family that 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 pair trade opportunities. As of July 29, 2022, the Fund generated a 1 YR return of 22.08% versus -2.23% for the 5 YR return. The Fund has a management fee of 1.10% with gross expenses of 1.81%.
Example: Vanguard Market Neutral Investor Fund
Because it is a market-neutral strategy, the Vanguard Market Neutral Fund Investor Shares fund uses long and short-selling strategies, unlike the firm's other mutual funds, which only buy and sell long positions. The fund's strategy aims to minimize the impact of the stock market on its returns, meaning the fund's returns may vary widely from those of the market.
Although most funds that short stocks, such as hedge funds, do not disclose their short holdings because SEC rules do not require them to, the Vanguard Market Neutral Investor Shares does publish its shorts. It chooses short positions by evaluating companies by five categories: growth, quality, management decisions, sentiment, and valuation. Then, it creates a composite expected return for all of the stocks in its universe and shorts those with the lowest scores.