Market Neutral Investing, Me Vs. Vanguard

| About: Vanguard Market (VMNFX)

Summary

Vanguard's VMNFX is a market-neutral mutual fund that uses long- and short-selling strategies to generate growth while maintaining zero beta.

It has a rather high expense ratio at 1.64%, and a minimum initial investment of $250k.

I have a market neutral stocks and bonds strategy with a 0% expense ratio and $0 minimum investment.

My strategy has outperformed VMNFX over its lifetime, and would have outperformed even if the bond fund had generated half as much alpha as it did.

Why Zero Beta?

I love the idea of zero beta investment strategies. Rain or shine, bull market or bear, a good zero-beta strategy consistently generates growth. What more could you want?

I want to briefly highlight the difference between beta-0 and beta-1 strategies.

  • An alpha-generating strategy with net beta of 1 on average beats the market regardless of whether the market is up, down, or sideways.
  • An alpha-generating strategy with net beta of 0 on average grows regardless of whether the market is up, down, or sideways.

Both are very appealing. On some level I favor beta of 1. Who wouldn't like to consistently beat the market year after year, whether that means gaining 12% compared to the market's 10%, or losing only 3% when the market drops 5%?

When the market is down, it's nice to beat the market, but it's even better to generate positive growth. That's the appeal of a zero-beta strategy.

It is difficult to generate meaningful growth from a zero-beta strategy, since all of the growth has to come from alpha generation.

How to Achieve Zero Beta

There are two primary ways to achieve zero beta:

  1. Buy one stock and short-sell another (usually in the same sector). You profit if the buy outperforms the sell, even if both decline. But with short-selling costs the deck is stacked against you.
  2. Combine one or more positive-beta funds with one or more negative-beta funds in the appropriate allocation.

In order for (1) to work, you have to be a good stock picker. In other words, (1) doesn't work (partial joke).

All that (2) requires is identifying a fund with positive alpha. If its beta is 0, you're set; if its beta is positive, combine it with the ProShares Short S&P 500 ETF (SH); if its beta is negative, combine it with the SPDR S&P 500 Trust ETF (SPY). A key point is that at least one of your funds has to have positive alpha, otherwise your strategy will be worse than cash.

Vanguard's Stock Pickers

The Vanguard Market Neutral Fund Investor Shares (MUTF:VMNFX) is a mutual fund that tries to generate growth from strategy (1), although not necessarily with every buy matched to exactly one short.

VMNFX has operated since Nov. 11, 1988, has an expense ratio of 1.64%, and has a $250k initial investment minimum. The fund managers are James D. Troyer, CFA, James P. Stetler, and Michael R. Roach, CFA.

Interestingly, despite the $250k minimum, Vanguard states that "the fund may be appropriate for a small portion of an already well-diversified portfolio." If $250k is a small portion of your portfolio, well done!

The stated goal of VMNFX is to "provide long-term capital appreciation while limiting exposure to general stock market risk."

Also straight from the prospectus:

The overall performance of the Fund depends on the net performance of its long and short positions... If the Fund's investment strategy is successful... the net performance of its long and short positions will produce long-term capital appreciation that reflects the quality of the advisor's security selections...

In other words, VMNFX's performance depends on how well its advisors pick stocks.

My Strategy

My strategy is based on my Nov. 2015 article Towards A Zero-Beta Stocks And Bonds Portfolio. Here I use the same exact idea but with the Vanguard 500 Index Fund (VFINX) and the Vanguard Long-Term Bond Fund (VBLTX) instead of SPY and the iShares 20+ Year Treasury Bond ETF (TLT).

I planned to use the Vanguard Long Term Treasury Fund (VUSTX) rather than VBLTX, as it is more similar to TLT. But I want the results to generalize to an ETF version of the strategy, and an ETF version of VUSTX is not available. Note that results for VFINX/VUSTX are quite similar to VFINX/VBLTX.

Anyway, here is the method:

  • Use the first 51 trading days (i.e. 50 daily gains) to estimate VBLTX's beta. Buy $10k of VFINX and VBLTX, allocated for zero beta. Update balances in each fund based on the next daily gain.
  • Slide over 1 day and re-calculate VBLTX's beta. Determine the effective beta based on the current VFINX and VBLTX balances.
  • If effective beta is between -0.15 and 0.15, do not rebalance, and update balances in each fund based on the next daily gain.
  • If effective beta is outside (-0.15, 0.15), rebalance to 0 and update balances in each fund based on the next daily gain.

I assume no-cost trades, which would be possible if one was trading the ETF versions of VFINX and VBLTX (the Vanguard S&P 500 ETF (VOO) and the Vanguard Long-Term Bond ETF (BLV), respectively) in a Vanguard account.

I Win!

The figure below shows growth of $10k for my strategy, Vanguard's market neutral fund VMNFX, and VFINX, and the table shows performance metrics.

Figure 1. Growth of $10k from Nov. 16, 1998, to March 18, 2016. Click to enlarge

Table 1. Performance metrics since VMNFX's inception.
Strategy Growth (%) MDD (%) Sharpe Alpha (%) Beta
My strategy 159.3 16.7 0.049 0.023 0.022
VMNFX 45.8 26.0 0.019 0.011 -0.030
VFINX 116.5 55.3 0.021 0 1
Click to enlarge

My strategy and VMNFX both achieved approximately 0 beta, but mine had more than 3x growth, a smaller MDD, much better Sharpe ratio, and generated more than 2x as much alpha. Also, I didn't put it in the table, but daily gains for my strategy had a higher mean and lower standard deviation than daily gains for VMNFX.

My strategy also outperformed VFINX, which is very good for a market neutral approach.

Cut VBLTX's Alpha in Half, Still Outperforms

Bond funds have performed extremely well since 1998. What can we expect when they perform more moderately?

Well, let's see what would have happened if VBLTX had only generated half of the alpha it did.

Figure 2. Growth of $10k from Nov. 16, 1998, to March 18, 2016, after subtracting out 50% of VBLTX Click to enlarge

My strategy still edges out VMNFX (better growth, higher Sharpe ratio, smaller MDD).

Conclusions

I believe that a well constructed zero-beta stocks and bonds portfolio is a better play than a market neutral fund that relies on stock picking.

My strategy will perform poorly if/when the bond fund experiences negative alpha, which can happen when interest rates rise suddenly. But in general one can expect long-term bond funds to generate positive alpha as a result of maturing bonds.

I didn't want to play with too many parameters, to avoid curve fitting or data mining or whatever you want to call it. But I do want to mention that increasing the moving average window seemed to improve performance, as did using an effective beta tolerance smaller than (-0.15, 0.15).

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The author used Yahoo! Finance to obtain historical stock prices and used R to analyze the data and generate figures. Any opinion, findings, and conclusions or recommendations expressed in this material are those of the author and do not necessarily reflect the views of the National Science Foundation.