Market-neutral strategies offer way to hedge latest rally

With the S&P 500 up more than 18% since the start of the year and almost 60% from the March 9 market low, it might be easy to make a case for long or even leveraged-long equity exposure.

However, given basic logic and recent history, it might make more sense to consider some calculated preparation for the stock market’s next move.

One way to hedge the market’s rally is to allocate assets to select equity market-neutral strategies.

The basic market-neutral strategy — which is typically associated with hedge funds, but can also be found in some mutual funds — is designed to neutralize the market’s beta and produce performance through manager-generated alpha.

Last year, for example, when the S&P 500 declined by more than 38%, the average market-neutral hedge fund lost less than 3%.

That is the kind of low correlation to the broader equity markets that financial advisers and their clients would have appreciated last year.

The flip side of such a low correlation to stocks was a return for the category of just 4.3% through August, compared with a 13% gain by the S&P 500 over the same period.

Although a 4.3% return through August in the context of such an enthusiastic stock market rally might trigger some investor inquiries, it is reflective of a legitimate objective — non-correlated performance.

“There were a lot of professionals who thought they had non-correlated investments last year, only to find out they didn’t, and now people are really revisiting portfolio construction,” said Timothy Schwider, a quantitative equity portfolio manager at Credit Suisse Asset Management LLC.

The lower beta of market-neutral strategies, which is calculated at about a 23% correlation to the broad equity markets, is the initial case for an allocation to market neutral.

The lower the beta of a particular fund, the more it will help bring down standard deviation or volatility.

According to Credit Suisse, between July 1999 and June, the standard deviation of market-neutral hedge funds, at 3%, was lower than that of any other hedge fund category.

The standard deviation of the S&P 500 during the same period was 16%.

The beauty of low correlation and low volatility is that the investment entry point is less of an issue, because if the manager is disciplined, the returns should remain smooth.

The potential rub, however, involves the manager and the variance that can emerge. Most market-neutral strategies are built on a quantitative investing foundation, but the qualitative flexibility of management can vary.

For example, the TFS Market Neutral Fund (TFSMX) is a registered mutual fund that had gained more than 16% year-to-date through last Tuesday. The $720 million fund, which is managed by a team at TFS Capital LLC, was down 7.3% last year, suggesting lower beta.

But the fund’s return this year could be an indicator that it is taking on increased beta, or market-related risk.

“When you start to see wild swings you’re not getting a true market-neutral fund,” said Nadia Papagiannis, a mutual fund analyst at Morningstar Inc.

Morningstar doesn’t specifically track market-neutral mutual funds, but she analyzed the performance of a dozen funds that are identified by name as being market neutral. Of the group, the TFS fund’s return this year was nearly double that of the fund with the next best performance.

Four of the mutual funds analyzed had declines this year of between 9.4% and 19.8%. Ms. Papagiannis interprets that performance as indicating either a “bad manager” or a strategy that has strayed from its market-neutral goal.

To be fair, it would be nearly impossible for a market-neutral strategy to achieve true zero beta, but investors turning to the strategy for non-correlation should recognize the double-edged sword of whatever amount of beta is present.

“Beta is a handicap if the market is down, or wind in our sails if the market is up,” said Larry Eiben, TFS’ chief operating officer.

A new Investment Insights column appears every Monday on InvestmentNews.com. E-mail Jeff Benjamin at [email protected].