Summary

What was supposed to be so great about market neutral mutual funds? That is exactly what some investors have been asking themselves after a rough start — including some sizable early losses — for these unusual and supposedly low-risk funds.

Market-neutral funds aim to deliver decent returns in both good and bad markets. The trick is splitting assets between purchases of promising stocks and short sales of other stocks expected to be lagging performers. (In a short sale, an investor sells borrowed shares of a stock with the intention of purchasing the shares later at a lower price.) Balancing long and short positions is supposed to neutralize the effect of the broad market’s overall direction.

What was supposed to be so great about market neutral mutual funds? That is exactly what some investors have been asking themselves after a rough start — including some sizable early losses — for these unusual and supposedly low-risk funds.

Market-neutral funds aim to deliver decent returns in both good and bad markets. The trick is splitting assets between purchases of promising stocks and short sales of other stocks expected to be lagging performers. (In a short sale, an investor sells borrowed shares of a stock with the intention of purchasing the shares later at a lower price.) Balancing long and short positions is supposed to neutralize the effect of the broad market’s overall direction.A market-neutral fund can make money in any type of market as long as its long stock holdings — those that it owns — perform better than the stocks the fund has sold short.

They are, for better or worse, the purest way to capture a manager’s ability, says Eric Remoule, manager of Warburg Pincus Long-Short Market Neutral Fund.

Unfortunately, market-neutral managers haven’t been looking too able since these funds began appearing a year or so ago. Market-neutral funds were one of the big disappointments of 1998, declared early fan Ken Gregory, publisher of No-Load Fund Analyst newsletter, in a recent issue. And these funds have been performing even worse in early 1999.

For instance, the first and biggest of these funds, Barr Rosenberg Market Neutral Fund, has posted a negative 5.9 percent return so far this year and a negative 6.1 percent return since its late-1997 start. There’s nothing neutral about that, says Robert Markman, an investor adviser and mutual-fund manager in Minneapolis who has been a market-neutral doubter.

While new market-neutral funds continue to appear, early ones such as Barr Rosenberg Market Neutral and Phoenix-Euclid Market Neutral Fund have seen their assets decline in recent months.

Is the concept of market-neutral investing flawed? Several market-neutral fund managers, who have run institutional market-neutral accounts for years, insist the answer is no. This has worked very well over time, but it doesn’t work all the time, says David Katzen, manager of the Phoenix-Euclid fund.

Since his firm began running market-neutral accounts in 1990, Katzen says, the average annual return has been about 11 percent, while super-low-risk Treasury bills have returned about 5 percent. Most market-neutral managers aim to beat the T-bill return by four to six percentage points.

At the very least, the early results of the market-neutral funds spotlight the limitations and complexities of running money in this style. While the funds aim to be neutral to the market’s overall direction, for instance, many place bets — albeit small ones — on stocks of a particular style or market capitalization or industry. Recently, most of those bets haven’t paid.

Early advocates such as Gregory of the No-Load Fund Analyst continue to recommend market-neutral funds. But others see confirmation of their decision not to bother. Says Markman: I just don’t get it. I just don’t get going through all that effort to try to make a few percentage points more than a T-bill.

One of the biggest problems for market-neutral managers recently has been the extreme margin by which growth stocks, issued by fast-growing companies, have trounced seemingly cheap value stocks. Several managers say their funds have a slight tilt toward value. That doesn’t hurt performance in most market environments, says Katzen of the Phoenix-Euclid fund, but what has thrown us for a loop here is the magnitude of the difference between growth and value returns.

The recent stock market has also been unusual in the extreme dominance of large stocks over small ones, and that has hurt at least one market-neutral fund. While some funds, including Barr Rosenberg Market Neutral, aim to be capitalization-neutral, Dreyfus Premier Market Neutral Fund has had both a value bias and a small tilt against large companies, primary manager John Cone indicated through a Dreyfus spokeswoman.

Given the recent results, why should any investors bother with market-neutral funds? Two main cases can be made.

The returns of market-neutral funds aren’t correlated to those of the broad stock market, so adding a market-neutral component to a diversified portfolio can cut overall volatility.

Most individuals are loaded with investments that depend to a great extent on the continuing bull market in stocks or the benign interest-rate environment we have had for bonds, says Katzen of the Phoenix-Euclid fund. What continues to be very attractive about market-neutral investing is that its returns are not dependent on either of those two things.

Further, if market-neutral funds hit their target returns, that performance won’t be too shabby compared with some alternatives. Gregory, the No-Load Fund Analyst newsletter publisher, notes that market-neutral funds are about as risky as bonds but are likely to beat the under-5 percent annual returns he expects from bonds over the next five years. We believe these odds are too great to pass up, he says, even after the inauspicious recent results.

The No-Load Fund Analyst is recommending that most investors keep 15 percent of their portfolios in market-neutral funds. But after the ugly 1998, the San Francisco newsletter has adopted a strategy used by many institutional investors. It is now recommending that subscribers diversify their market-neutral exposure among two or more funds.