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Let's face it — the broader equity markets are in a rut. A 'rut' may even be painting a rosy picture. Data coming out of the United States shows definite signs of weakening in vital areas of the economy such as housing and consumer confidence.
The Dow Jones Industrial Average, the S&P 500, the NASDAQ Composite and even the oil and metals-rich S&P/TSX Composite are well off their 6-month highs.
If markets continue down a path of trendless mystery the retail investor basically has two options: Wait it out, or buck any market trend and find a way to chart your own course. One way to do that is through market neutral hedge funds.
It's important to first know what a market neutral hedge fund is and what it sets out to accomplish. A market neutral investor seeks to profit from both increasing and decreasing prices in a broad market. This is obtained by employing one or many hedge strategies including simultaneous long and short positions and merger arbitrage (when two merging companies are bought and sold at the same time to generate a low-risk profit). Investors who hold a market neutral position can potentially benefit from any market momentum — up or down.
With market neutral hedge funds it's all about good management so investors must do their homework. The level of risk can range from extremely high to extremely low depending on who is at the helm, which in itself presents a further element of risk.
Some market neutral funds trade on major stock exchanges and some are packaged as mutual funds. Technically, any hedge fund could be considered market neutral because it is not dependent on general market trends, but 15 basic funds are specifically sold as market neutral on the Canadian market.
Hedge funds are relatively new to the Canadian market so few have a track record beyond three years. The top performing market neutral fund over the past three years is RBC International Currency Neutral with an average annual return of 17.5 per cent. The fund falls into the category of International Equity because it can invest in derivatives or options that mimic underlying international stocks. Managers at State Street Global Advisors, Ltd. use derivatives to capitalize on potential gains in the underlying stock while hedging against potential losses in the same stock. It's a market neutral stock because it attempts to turn a profit regardless of the direction of the underlying equity — or the broader market.
Over the past three years the fund has outperformed the broader market benchmark. The RBC International Currency Neutral fund's benchmark is the Canadian dollar version of the Morgan Stanley Capital International — Europe, Australia, Far East Index. The MSCI-EAFE has returned an average 15.1 per cent annually over the past three year.
It may seem strange but good market neutral funds don't always seek to outperform the broader index. A good example is the SciVest Conservative Market Neutral Equity fund, which attempts to capitalize on the gains obtained by the S&P/TSX, but its main priority is to reduce risk. The fund lowers risk by dividing investments into three segments: a money market portfolio, long positions on stocks, and short positions on stocks.
The U.S. currency version of the SciVest Conservative Market Neutral Equity fund has returned 9.5 per cent annually over the past three years while the S&P/TSX has returned 20 per cent annually over the same period. Fund investors did not benefit from the broader market gains over the past three years but they were exposed to much less risk.
The most common measurement of risk is referred to as 'beta'. The benchmark beta is always '1'. A fund is riskier than the benchmark index if it is above one. If it is below one it carries less risk.
The RBC International Currency Neutral fund has a three year average beta of 0.56 compared with the MSCI-EAFE (Canadian dollars), while the beta for the average international equity fund is just under one. That means investors were exposed to less risk than the underlying index but still took in larger returns.
The three year average beta on the SciVest Conservative Market Neutral Equity fund is 0.34 compared with the S&P/TSX Total Return index. It falls into the category of 'alternative strategy' funds. The average alternative strategy fund has a 3 year beta of 0.56. The three year return for the average alternative strategy fund was 12.8 per cent. The SciVest fund underperformed the index and the group average, but investors were exposed to much less risk.
One risk all hedge funds have is their relative lack of disclosure. Unlike most mutual funds, hedge fund managers are not required to release specifics about strategy, holdings and the degree the fund is leveraged. Market neutral funds are a bit of a catch 22 in that you must accept some risk to reduce overall risk.
Dale Jackson has been a producer at Report on Business Television since its launch in September 1999.