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Market-Neutral Funds: Rx For All Markets
Instead of trying to figure out which way the market is headed
next—consider “market neutral” mutual funds.
Market-neutral funds are agnostic about market direction. In theory, they
generate positive returns whether the overall market moves down or up.
I know that sounds unrealistic. In fact out of 68 funds that say they
follow that strategy, I’ve only found three worth talking about. I’ll give
you their names in a minute, but first some background. I’ll start by
defining a market-neutral fund.
Most stock funds are “long-only” funds. They hold stocks that they expect
to move up.
There is another class of funds termed “bear-market funds.” They usually
short stocks (short sellers bet that the stocks they’ve shorted are headed
down instead of up) and profit when the market sector they’ve targeted
drops. However, since they lose money in a strong market, you have to be
able to predict market direction and get out before that happens.
Long & Short
Most market-neutral funds combine long and short strategies. They
hold long positions in stocks that they expect to move up and short stocks
that they expect to drop. For example, within a particular industry, a
fund might be long stocks that it views as underpriced and short
overpriced stocks. Also, many market-neutral funds may be long or short
relevant indexes to hedge their positions on individual stocks.
Finding Market-Neutral Funds
You can use Morningstar’s free Fund Screener to find market-neutral
funds. From Morningstar’s homepage (www.morningstar.com),
select
Funds and then
Fund Screener in the Tools section.
Use the Morningstar Category dropdown menu to confine your search to
Long-Short funds, which is the only relevant Morningstar category. The
screen listed 180 funds when I searched for long-short funds.
Next, I honed the list down by adding these requirements.
Manager Tenure
Manager tenure is the length of time the current manager has run the fund.
When you’re analyzing a fund, it’s important that the manager responsible
for it historical returns is still at the helm. I required at least three
years, which is a reasonable time to establish a track record. Cut that
requirement down to one-year if you want to see more funds.
Minimum Initial Purchase
There is no point in considering a fund if you have to come up with
$100,000 to make your first purchase. I specified $10,000 or less.
No Load Funds
The load is a sales commission that a fund charges to compensate the
financial advisor or stockbroker who turned you on to the fund. Since
we’re doing our own fund selection, I specified No-Load Funds Only.
Morningstar Star Rating
Morningstar rates funds from one to five stars, where five is best, based
on each fund’s historical returns compared to its volatility (how much its
share price bounced up and down along the way). I required a minimum of
three stars.
Those tests cut my Long-Short list down to 15 funds. Since the point of
this exercise is to pick funds that make money in up or down markets,
next, I ruled out all funds that hadn’t produced at least 2% returns so
far this year, as well as over the past 12-months.
Surprisingly, only three available Long-Short funds met those modest
requirements (the Georgetowne Long/Short also passed the tests, but that
fund is not available in California). Here’s the list.
1st Source Monogram Long/Short (FMLSX)
The fund’s managers employ fundamental analysis to pick undervalued stocks
to hold long and overvalued stocks to short. It holds mostly midcap and
large-cap stocks. As of August 26, the fund had returned 2.5%
year-to-date, and 5.8% over the past 12-months. Over the past three years,
the fund has returned 8.5%, on average, annually. For comparison, over the
same period, the S& P 500 Index has returned 4.8%, on average, annually.
Hussman Strategic Growth (HSGFX)
The manager considers both valuation and earnings momentum factors such as
recent earnings surprises and forecast earnings growth to pick individual
stocks for long positions. Hussman hedges by taking short or long
positions in index options. Hussman had returned 5.0% year-to-date, 5.3%
over the past 12-months, and 4.5%, on average, annually, over the past
three years (Disclosure: I hold a position in the Hussman fund).
TFS Market Neutral (TFSMX)
TFS is a quantitative fund, meaning that instead of pouring over financial
statements, the fund relies on a computer formula to pick small-cap stocks
to buy long or to sell short. TFS holds both long and short positions in
its portfolio. TFS must be on to something. The fund has returned 2.5%
year-to-date, 13.2% over the past 12-months, and 13.6%, on average,
annually, over the past three years.
These three funds are qualified market-neutral fund candidates, at least
by my criteria. To get a better idea of how they compare, try plotting all
three on the same price chart over varying time frames such as one or
three years. You can do that using the charts on Yahoo (finance.yahoo.com)
or on MSN Money (moneycentral.msn.com).
Also, keep in mind that in a strong bull market, these market-neutral
funds would likely underperform the major averages.
published 8/31/08 |
