The reality has been quite different. The few market-neutral funds introduced over the past 18 months have gotten off to a fitful start, often losing money while the stock market has roared to new highs. "We were obviously disappointed by our first-year results, and in fact we're not off to a good start this year, either," acknowledges Will Jump, director of market-neutral strategies for AXA Rosenberg Investment Management, which launched its Barr Rosenberg Market Neutral Fund in December 1997. "Nonetheless, we remain confident that our strategy is sound and that it will add value going forward." It would be tempting to dismiss Jump's optimism if it weren't for the fact that AXA has been successful in its marketneutral strategy for most of the past decade. During the nine years ended Dec. 31, 1998, for example, its market-neutral accounts for institutional investors posted gains in 32 out of 36 quarters. The Standard & Poor's 500-stock index, by comparison, turned a profit in 29 quarters.
Going Up ...And Down
That sort of consistency is one of the great attractions of market-neutral funds. It's achieved through a strategy that involves simultaneously buying stocks expected to go up in price and "selling short" those expected to go down.
In a short sale, a fund borrows stock from a broker and immediately sells it at the prevailing market price. Later, it buys back those shares—hopefully at a lower price—and returns them to the broker. The fund pockets the difference between the higher price at which it sold and the lower price at which it covered its position.
This long-short construct is designed to insulate a market-neutral fund from whipsaw movements in the stock market. If the market goes up, the fund can expect to lose money on its short positions overall but earn money on its long positions. If the market goes down, the fund can expect to lose money on its long positions but make money on its short positions. In the meantime, the fund will enjoy a steady stream of interest income on the proceeds of its short sales until those positions are closed out.
A Different Driving Force
Unfortunately for the Barr Rosenberg fund, its stock-selection strategy has not served it very well to date. The new fund performed admirably during last year's volatile third quarter, when it earned 1.8 percent while the S&P 500 was falling 10 percent (and the average domestic stock fund was losing 15 percent). But for all of 1998 the fund lost 1.1 percent, compared with a gain of 28.7 percent for the S&P 500.
The Barr Rosenberg fund uses proprietary computer models to select stocks that appear to be undervalued for its long positions and to find those that appear to be overvalued for its short positions. But over the past 18 months, the stock market has been driven by growth stocks, not by value plays.
"We've actually been able to add value [generate positive returns] in growth environments in the past, but this time the disparity has been too extreme," says Jump. Another market-neutral fund with a value-oriented stock-selection process, the Phoenix-Euclid Market Neutral Fund, was introduced last spring by Zweig Securities Corp. It hasn't fared any better. It lost 4.1 percent in last year's third quarter, and in the first quarter of this year it lost 7.1 percent. (The Barr Rosenberg fund lost 6.7 percent in the first quarter.)
To be sure, neither the Barr Rosenberg fund nor the Phoenix-Euclid fund seeks to outperform the S&P 500. Instead, their goal is to consistently earn a few percentage points more than 90-day U.S. Treasury bills, a common proxy for cash. For example, AXA Rosenberg's institutional market-neutral accounts earned an average of 14.2 percent annually over the past five years, compared with 5.1 percent for 90-day Treasury bills.
Making The Right Bets
If you think a market-neutral fund might be right for you despite this lackluster start, read its prospectus to make sure that the manager's stock-selection philosophy dovetails with your own.
As the Barr Rosenberg example illustrates, the stock-selection prowess of a market-neutral fund manager is integral to the fund's success. After all, the manager of an ordinary mutual fund with, say, $1 billion in assets must bet right on $1 billion worth of long positions to make money for the fund's investors.
The manager of a $1 billion marketneutral fund must be right not only on $1 billion of long investments but also on the $1 billion worth of short investments—for which no money was paid out upfront. In that respect, he or she is taking on twice the risk of the conventional fund manager.
The roaring bull market in growth stocks is working against market-neutral mutual funds. But one day that bull will finally slow down, and when it does, the market-neutral strategy may yet shine. At the very least, its history of success in the institutional market makes these funds worth watching a bit longer.
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