Market-Neutral Funds: Three Misconceptions

by: Christopher Holt

Alpha Male has been getting a lot of media inquiries recently about why market neutral funds lost money last month. It’s almost as if some of the more skeptical members of the press now smell blood in the hedge fund water. They see that there were market gyrations in August and that some market neutral funds were down. Ergo, market neutral funds aren’t that “neutral” after all.

In fairness, it’s easy for some to reach this erroneous conclusion. Through a grand game of “broken telephone” involving the industry and the popular press, the impression has been established that market neutral funds must have a low volatility, won’t move in the same direction as the markets, and will act as a hedge against market drawdowns.

But all three assumptions are wrong. Market neutral funds aim simply to have a low market correlation and, like all funds, they aim to produce alpha. That’s it. No automatic promise of low volatility, and certainly no promise that they will act as a hedge against a long position in the market.

By this standard, market neutral funds - even the stinkers - may have performed entirely appropriately in August after all.

The confusion begins with the definition of “low correlation”. We hear instances of this in phone calls from concerned institutional investors and we see examples in the way the media often reports on the growing numbers of market neutral mutual funds. This column by Brett Arends, mutual fund columnist over at the TheStreet.com is a case in point.

Arends reports that market neutral mutual funds managed by Denver-based Geronimo Funds performed so poorly in August that three of them were closed. Said Arends:

“Geronimo Multi-Strategy (GCHIX) plunged 9.36% through July and August, according to Lipper. Geronimo Sector Opportunity (GPSOX) fell 3.57%, and Geronimo Option and Income (GPOCX) fell 2.03%. All are down for the year.

“Ouch. How’s that for market neutral?”

He continues by describing a market neutral fund managed by TFS Capital as “far from neutral”:

“Investors in TFS Capital Market Neutral (MUTF:TFSMX) got a shock during the market rout in early August: Their investments proved far from neutral, losing a stunning 11.8% — or almost one dollar in eight — in just nine days.”

But Arends seems to have missed the point about what it means to be “market neutral”.

Let’s say you flip two coins. Obviously, the coin tosses are entirely independent and the result will therefore be entirely uncorrelated, right? Sure. But in roughly half the tosses, both coins will show the same side at the same time. How can this be when the coins are totally uncorrelated with each other?

This simplistic example illustrates that, in order to be market neutral, a fund must sometimes (in fact, quite often) show the same sign as the market – not because it is correlated to that market but because it is uncorrelated to that market. In other words, one-month returns simply cannot be used to determine if a fund is in fact, “market neutral”.

It turns out that The TFS Market Neutral Fund (TFSMX) actually has a very low market correlation and a one-year beta of only 0.20 to the market. Arends may have been expecting something else in August, but over the past year this performance is actually pretty close to neutral, not “far from neutral” as he suggests.

The Geronimo Funds had slightly lesser market neutral credentials. Their betas were in the 0.5 range (although one was 0.28). But these funds may well have closed – like so many hedge funds – simply because they failed to reach critical mass. The three funds that Arends says performed “so badly that last month that the company decided to shut them down” had assets of only $8m, $3m and $4m. Yes, August stank the joint out. And yes, that’s probably a good time to throw in the towel. But the funds seemed to have been closed for reasons other than not being market neutral.

Arends continues to confuse the issue when he suggests the Caldwell & Orkin Market Opportunity Fund (COAGX) is living up to its billing as market neutral. In fact, this fund has a 3 year beta of -0.55. This might be a great addition to a long only portfolio, to be sure. But it’s hardly market neutral.

He also cites The Diamond Hill Long/Short Equity Fund (DHFCX) as another successful market neutral fund. He acknowledges that this fund “is not technically market neutral” and he’s right about that. This fund has 1 and 5 year betas well over 0.50.

(In fairness, we agree with Arends on one thing. The Hussman Strategic Growth Fund (HSGFX) has a 3 year beta of 0.09. Now that’s closer to market neutral.)

The bottom line is that “market neutral” is not a panacea. It does not mean the fund will always make money. In fact, it doesn’t even mean that a fund will be less volatile than the market. It just means that most of the volatility will arise from the manager’s skill or stupidity, not from the market’s gyrations. And there is an equal chance that this skill or stupidity will occur in months when the market is up as there is when the market is down.

August may have taught some market neutral fund managers a few things about leverage, and others about the non-linear relationship between the market and their performance. But one month can tell us precious little about a fund’s claim to be “market neutral”.