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Don't Be Fooled by the Active vs. Passive Debate

Understanding the uses for active and passively managed statistical market-neutral offerings.  

Josh Charney, 07/12/2012

The active versus passive debate appears to be rearing its head in market-neutral offerings. As trading strategies become more commonplace, index companies are now rolling out market-neutral strategies. Enter passive, or index-linked, market-neutral exchange-traded funds. Although this advent leaves investors with significantly more choices than in the past, it also brings an added layer of complexity. Passive and actively managed market-neutral offerings, unlike the active/passive dichotomy among equity or bond offerings, aren't simpler, cheaper versions of products. 

Active vs. Passive
Passive market-neutral ETFs track specialized indexes that follow a trading strategy. Trading strategies aren't run by managers and surely will not work in every market environment. A successful trading strategy could be assigned a fixed portfolio allocation and used as a hedge, but a more appropriate use would be to tactically allocate to these offerings during certain market environments. These ETFs serve to enhance investors' tool kits, while actively managed statistical market-neutral funds could be assigned a fixed portfolio allocation.

Evolving Models
The benefit of having a manager at the helm is so that he can adjust the models as market environments change. Highbridge Statistical Market Neutral HSKAX (Neutral) employs a stock-selection and risk-management approach as part of its process. The fund bases its stock selection on four themes: fundamental, relative value, event-driven, and technical. The fundamental value models look for higher-quality companies, while the relative value analysis emphasizes current price multiples such as price/earnings and price/cash flow ratios. Event-driven monitors incorporate news and buy/sell recommendations of Wall Street analysts, and its technical models seek to exploit short-term supply and demand imbalances by providing market liquidity. The risk-management component attempts to insure risk factors such as market, sector, and capitalization betas are neutralized.

This strategy, though, isn't perfect. The fund's performance has been lacking over the past few years (down an annualized 3.7% from 2009 through 2011). The crux of its lackluster performance was the market's “flight from quality,” in which markets turned against quality names and in which depressed lower-quality stocks rallied. In 2010, management made three enhancements to its models. First, it adapted its long-term models by rotating out stale ideas more quickly. Second, management re-engineered the technical models to factor the impact of high-frequency traders. Third, it made the models more aware of transaction costs. Although these developments are positive, the fund's limited track record hasn't demonstrated the effectiveness of these changes.

The Passive Side of Market Neutral
The other subset of statistical market-neutral funds follows a static index. Although they aren't run by a manager and can't adapt to new market environments, they do have the key advantage of being transparent. Because passive funds track an index, investors are privy to its methodology and, thus, historical track records. Two market-neutral funds that track back-tested indexes are QuantShares US Market Neutral Momentum ETF MOM and QuantShares US Market Neutral Anti-Beta ETF BTAL. The two indexes track the Dow Jones Thematic Market Neutral Momentum and Dow Jones Thematic Market Neutral Anti-Beta, which have historical track records going back to 2002.

The QuantShares momentum ETF attempts to profit off of positive and negative momentum movements. The fund takes long positions in the top 20% of highest-momentum stocks, of 1,000 eligible securities in the Dow Jones U.S. Index, and shorts the 20% of stocks with the most negative momentum. The index calculates momentum based on total return; stocks with the highest 12- month trailing return have the strongest momentum, while stocks with the lowest total returns exhibit the most negative momentum. The QuantShares anti-beta ETF is constructed similarly, as the fund goes long low-beta stocks and moves to short high-beta stocks, hence the “anti-beta.” It targets the same investable universe of stocks. To insure market neutrality, the ETFs attempt to be both dollar- and sector-neutral.

The Tactical Use of Passive
The performance track records of these offerings are mixed. Both products tend to perform well during times of strain. The anti-beta index has historically performed extremely well during 2008 (gaining 35.5%), as high-beta stocks tanked by more than low-beta equities. Both indexes, however, faired poorly during 2009 and 2010. The momentum index fell 27.2%, and the market-neutral anti-beta index fell 27.3%. Momentum-based strategies tend to perform well when markets are trending, such as during 2008, when the managed-futures category increased 8.3%.

The anti-beta index, historically, exhibits much better risk-adjusted returns than the momentum index, as measured by Morningstar risk-adjusted returns, since inception. Market-neutral mutual funds, however, have exhibited better risk-adjusted returns than both the two indexes as well as the S&P 500, over the past 10 years. But these indexes can still be useful hedges--the correlation of the momentum and anti-beta indexes are negative 0.36 and negative 0.79, respectively, compared with the S&P 500. These indexes, thus, may be better suited as tactical plays during market turbulence, as opposed to strategic, long-term fixed portfolio allocation.

Slow and Steady?
Market-neutral offerings should offer investors superior risk-adjusted returns, not necessarily better absolute returns. The momentum and anti-beta ETFs, however, exhibit significantly more volatility than the category (the anti-beta index exhibits even more standard deviation than the S&P 500). These offerings, therefore, may be decent alternatives to investors who crave market-neutral offerings but dislike the low-risk, low-return nature of these strategies.

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Josh Charney is an alternative investments analyst at Morningstar.
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