PRACTICING SAFE ZACKS: STOCK RATER PLANNING MARKET-NEUTRAL FUNDS

Zacks Investment Research Inc. — a company known best for tracking corporate performance and Wall Street analysts’ expectations — is getting into the mutual fund business.

The Chicago company, which has been managing money for retirement plans since 1994 and now has $320 million under management, plans to launch two mutual funds by mid-November. The funds, which will be sold through brokers, financial advisers and other go-betweens, will employ a market-neutral strategy.

“Until now, we haven’t had anything for the individual investor,” says Ben Zacks, president of Zacks Investment Management, the money-management arm of the 21-year-old company. “It’s just a natural extension of the investment vehicles we currently offer.”

Market-neutral mutual funds split their portfolios between long and short stock positions.

By combining these strategies, market-neutral funds aim to deliver decent returns during both good and bad markets.

Market-neutral funds first came on the scene in 1997 after the passage of the Taxpayer Relief Act, which repealed the prohibition against funds making more than 30% of their profits from short selling.

Despite its history of making money for institutional investors by using a market-neutral approach, Zacks faces an uphill battle in trying to sell the funds to average investors. While many market-neutral funds were touted as enabling investors to sleep at night, nothing could be further from the truth.

With few exceptions, anyone who bought into a market neutral fund at the beginning of this year is losing money. Of course, it remains to be seen how these funds will perform in a real down market, when a hedging strategy really shows its worth.

not a good year

Barr Rosenberg Market Neutral Fund — the industry’s first — has fallen 13.31% this year through Sept. 27; Phoenix-Euclid Market Neutral Funds is off 3.71%; Puget Sound Market Neutral has dropped 0.10%, and Warburg Pincus Long-Short Market Neutral Fund has fallen 3.64%.

One explanation for the poor performance, say experts, is that many market-neutral funds tend to favor value stocks, a segment of the market that until recently has been in the doldrums.

Another is that many market-neutral managers may have sold Internet stocks short early in the year — a strategy that would not have panned out until much later.

Making matters worse, few investors are likely to take the time to understand how a market-neutral fund works — let alone invest in one, says Scott Colley, an analyst at Morningstar Inc., the Chicago-based fund tracker.

“Oh, God, I’d hate to be a broker trying to sell these funds,” he says. “The typical investor is just not going to get this product.”

It’s a point that even Mr. Zacks is willing to concede. “Market-neutral funds would certainly appeal to the more knowledgeable investor, without a doubt.”

That isn’t stopping the company from attempting to bring them to a larger crowd. Through a new subsidiary known as Zacks Mutual Funds, the company will push the Zacks Market Neutral Fund and the Zacks Index Plus Fund. Index Plus will invest primarily in shares of the Market Neutral Fund while also using Standard & Poor’s 500 stock index futures to add zip to returns.

Both funds will be managed by Mr. Zacks and will have a load of 4.5%, according to documents filed with the Securities and Exchange Commission. The load will be waived if sold through a fee-based adviser.

The Market Neutral Fund will have annual operating expenses of 2.50%, while the Index Plus Fund will cost shareholders 2.85%.

While the funds will initially be sold through intermediaries, the company also plans to make the funds available directly to investors, although the load will not be waived. The company is even toying with the idea of selling the funds directly to investors without a load — a risky strategy that would have it straddling both sides of the fence.

“Funds that perform well will sell through whatever channel,” says Hubbard Garber, a spokesman for Zacks. “Funds that don’t perform well don’t sell through any channel.”