Specialized Funds: Market Neutral
Market neutral funds, also known as long/short funds, are investments that seek to deliver consistent returns 3% to 6% above three-month treasury bill yields, regardless of what direction the overall market moves.
Reasons to consider market neutral funds
- Seek to generate positive returns regardless of market conditions
- Provide a potential hedge against market declines
- Professional security selection and portfolio management
In a market neutral fund, managers hold both long and short positions. When markets go up, the intent is that the dollar value of the long positions will rise more than the short positions decline. Conversely, when markets go down, the money that is made through the short positions should be greater than the losses generated by the long positions. Because these funds tend to generate returns that are independent of the market's overall direction, they are often referred to as uncorrelated investments. These funds can maintain long and short positions in many different types of securities, including domestic and international stocks, exchange-traded funds (ETFs), bonds, currencies, and commodities.
Understanding the risks of market neutral funds
Market neutral funds are complex financial instruments that should only be used by sophisticated investors. While some of the risks are described below, this list is not exhaustive and other risks may exist. Because security selection and active management are such important components of a market neutral strategy, these types of funds tend to have higher-than-average fees. Over time, these fees could detract from long-term returns.
Returns are highly dependent on security selection. If a fund manager doesn't execute the strategy well, the funds could experience what is known as "convergent impact," in which the value of your investment could decline faster than the overall market.
The market neutral strategy requires significantly higher volume trading than other types of funds. Not only does this drive up fees, it can also have significant tax consequences. For this reason, market neutral funds are not recommended for taxable accounts.
During a significant market decline, fund managers may have a difficult time shorting certain stocks, due to recent changes in the "uptick rule" that limit short selling. In addition, stocks targeted for short selling by a manager may be hard to borrow, which could make it very difficult to deliver the shares to a buyer on the other side of the transaction. This could have a negative impact on fund managers' ability to effectively execute a market neutral strategy.
Market neutral funds may also depend on options to hedge certain risks. For instance, some buy put options to manage downside risk, or purchase derivatives that protect investors against a loss by locking in a sale price for securities they own. Fund managers may also buy call options, which can lock in a gain at a certain price to generate income.
Investments in market neutral funds can entail unique risks, such as convertible securities risk, options risk, short sale risk, interest rate risk, credit risk, high yield risk, liquidity risk, and portfolio selection risk.