Should You Invest in Market Neutral Funds?

I was recently asked by a reader named M.M. about the benefits of investing in market neutral funds.

Equity market neutral funds hold long/short stock positions and aim to capitalize on investment opportunities in a specific group of stocks while keeping neutral exposure to broader groups of stocks either by sector, market size, or country.

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Aside from stocks, some market neutral strategies invest in other asset classes like bonds (NYSEARCA:AGG), currencies, commodities (NYSEARCA:DBC), and even volatility (NYSEARCA:VXX).

One of the primary selling points of market neutral strategies is their distinction for having the lowest correlation with other alternative investing strategies.

How has the performance of market neutral funds been?

ETFs linked to market neutral strategies haven’t been good performers.

The IQ Hedge Market Neutral Index (NYSEARCA:QMN) has risen just +2.95% over the past 3 years compared to a +49.89% gain for the Vanguard Total U.S. Stock Market ETF (NYSEARCA:VTI) and a gain of +48.36% for the SPDR S&P 500 ETF (NYSEARCA:SPY).

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Similarly, the HFRI Equity Market Neutral Index, one yardstick of hedge funds that employ a market neutral strategy, has gained just +3.18% annualized over the past five years through August 2015.

The sponsor of QMN describes the fund this way:

“The IQ Hedge Market Neutral Index seeks to replicate the risk-adjusted return characteristics of the collective hedge funds using a market neutral hedge fund investment style. These strategies seek to have a zero “beta” (or “market”) exposure to one or more systematic risk factors including the overall market (as represented by the S&P 500 Index), economic sectors or industries, market cap, region and country. Market neutral strategies that effectively neutralize the market exposure are not impacted by directional moves in the market.”

QMN has just $13.5 million in assets and charges annual expenses of 0.90%.

Personally, I’m not a big fan of market neutral funds. But if you’re going to buy them, they don’t belong inside your core portfolio but rather inside your non-core portfolio. The non-core portfolio is always much smaller in size compared to your core.

In summary, if you want to be neutral on the stock market, own cash. It’s cheaper than buying a market neutral fund, it’s more liquid, and it’ll probably even perform better.

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