Investors may get more risky than they bargained for from market-neutral funds

By S ANDRA W ARD

I t’s hard to remain neutral about market-neutral investing strategies, the latest fad to emerge in the mutual-fund industry.

It’s an exciting opportunity for fund investors, gushes Gerard Breitner, president of Manhattan’s ExComp Asset Management, an investment adviser.

Simply put, market-neutral funds aim to deliver above-market returns with lower risk by hedging bullish stock picks with an equivalent, but diversified, number of bearish, or short, bets. Some income is also generated from the interest earned by placing the cash proceeds of the short sales in a money-market account. But, make no mistake, there’s really nothing simple about market-neutral funds.

The goal, humble or ambitious depending on your perspective, is to deliver consistent returns ranging anywhere from, say, 3 to 6 percentage points above Treasury bills, after fees, in bad conditions and in good. Variations on the theme, however, are considerably more juiced up. There’s the so-called double alpha or double whammy approach, which packs a punch by leveraging the portfolio using futures and options and promising twice the returns — at twice the risk.

While there’s considerable debate on whether market-neutral funds are conservative or risky, most everyone agrees that they’re not for the faint of heart. Nor are they for the uninitiated. We think it is the best newest thing since sliced bread, says Harold Evensky, a financial adviser with Evensky Brown Katz & Levitt of Coral Gables, Florida. We are big believers in the concept. But it’s confusing. And I don’t think it’s quite as guaranteed as it sounds. We want to see how it goes. You have to get people used to that kind of thing.

Still, Evensky has placed a small percentage of assets in the fund as part of an equity allocation. On the other hand, Richard Bregman, a financial adviser at MJB Asset Management in Manhattan, is steering clear.

I can’t understand it, he confesses. I tried to. How can you invest in something you don’t understand?

Though all the rage now, market-neutral strategies are really nothing new. The A.W. Jones investment partnership, commonly thought of as the first hedge fund, took a market-neutral approach when it was established in 1949. In the nearly 50 years since then, the market-neutral approach has remained in the realm of hedge funds and separately managed accounts. Until last summer, that is, when tax changes led to a popular revival of sorts in the strategy.

The repeal of the short-short rule under the Taxpayer Relief Act of 1997 made it possible for mutual funds to peddle such a product. The rule had prohibited mutual funds from deriving more than 30% of their income from short-term gains, which by definition included those on securities held less than three months. All gains from short sales and derivatives were considered short-term.

Market-neutral funds are also on the tips of everyone’s tongues these days because the staid fund industry is always looking for a product with that certain something special to spice things up. Also, once investors got a whiff last fall of the market’s darker side, the search was on for anything remotely resembling a defensive investment vehicle.

First out of the block with a mutual fund adhering to a market-neutral approach was Barr Rosenberg, a quant shop founded by the man of the same name, which launched a market-neutral fund in December and plans to introduce a Double Alpha Market fund soon.

The approach is a familiar one at Barr Rosenberg: The firm’s been managing private money using market-neutral models for almost a decade. Yet, only in the past few years, after much tweaking and fine-tuning, were the returns anything to write home about.

According to investment advisers Litman/Gregory & Co. big fans of the market-neutral strategy, Barr Rosenberg’s approach delivered an annual compound return of 2.98% between March 1989 and August 1992, before fees. After adjustments to include earnings changes and investor sentiment, the strategy worked a bit better: annual compound returns jumped to 9.87% between August 1992 and June 1995. More fiddling to remove any market-capitalization constraints freed the fund up to fully take advantage of overvalued and undervalued stocks and boosted the performance significantly — to 22.10% compounded annually through October 1997.

Already, the fund has attracted about $200 million in assets, mainly because Barr Rosenberg is a favorite of financial advisers, especially those in the asset-allocation crowd who have been pleased by the performance of its other funds.

Litman/Gregory, for instance, has recommended allocating 5%-21% — with the higher weightings for more conservative accounts — of the assets in its model portfolios to the Barr Rosenberg fund, based on confidence in our ability to assess the market-neutral strategy and Rosenberg’s abilities as a market-neutral manager, plus our return expectations from competing asset classes. The fund is up 0.20% year-to-date, compared with the average equity fund’s 11% performance and the 1.46% delivered by the Vanguard Index Intermediate Bond fund and the 1.39% return of the Lehman Intermediate Bond Index.

Other market-neutral funds due out include Montgomery U.S. Market Neutral, Value Line Hedged Opportunity and Zweig Euclid Market Neutral. Boston Partners Asset Management plans to join the pack this summer.

But there are real risks to these funds, despite the contention of many that they act as a substitute for bonds.

It appears to be a more conservative vehicle, says Michael Lipper, president of Lipper Analytical Services. But it’s an expensive vehicle, and it may not be ideal for taxable accounts. Indeed, investors will pay a steep price for the finesse it takes to keep a delicate hedge in place, not to mention all the trading. Expect hedge-fund-like management fees of at least 2%-2.5% of assets and a doozy of a tax bill. And really, the only bond-like feature of such funds is that their long-term returns tend to mimic those of fixed-income paper. Actually, these funds are often labeled as an alternative asset class because they can be linked to equities or bonds via the futures market.

There are more nagging concerns about market-neutral funds.

Unlike hedge funds and private accounts, market-neutral mutual funds are subject to the vagaries of cash flows which could add considerably to the difficulties of maintaining a hedge. If antsy investors, say, decide en masse to yank money out of the fund, it could pose major problems. Then there’s the possibility of what Lipper refers to as convergent impact-the chance that the shorts go up and the longs go down. That kind of danger highlights just how important stock selection, careful attention to risk exposure and portfolio matching are to the success of this type of fund.

There’s potentially a bigger pitfall, however, that lends considerable downside to this strategy, according to Ted Aronson, a partner in Philadelphia’s Aronson Partners, which manages $500 million based on market-neutral strategies.

Concerns about how to continue to sell short in an extended market decline when stocks can be shorted only on an uptick — that is, when the most recent price change is higher than the last — keeps Aronson sleepless.

The uptick rule is a problem in the extreme, Aronson declares. We’re scared about it. We spend a lot of time noodling what to do with it. That’s the biggest issue that keeps me up at night — the trading.

Sloppiness or flawed models can also do investors in, he notes, mindful of the collapse of Askin Capital Management in 1994 from a supposedly market-neutral bet on exotic mortgage-debt securities supposedly immune to changes in interestrate direction.

Cautions aside, Aronson remains a big advocate of market-neutral investing and considers it absolutely appropriate for mutual funds.

Says he: The strategy makes so much sense.

Questions:

1. Simply put, market-neutral funds aim to deliver above-market returns with lower risk by hedging bullish stock picks with an equivalent, but diversified, number of bearish, or short, bets. What has to be true for this strategy to earn excess returns?
2. What might be some of the problems associated with implementing this strategy?
3. As an investor, when would you choose to invest in market neutral funds? Could you accomplish the same objective, at least partially, by your own asset allocation decisions? If so, how would you do it?