Investors may be down on market neutral strategies, but they shouldn’t be out...
The market-neutral category was one of the few alternative mutual fund categories to experience outflows in 2012. (The only others to receive small net redemptions were our "trading" leveraged and inverse index categories). Although market neutral was not the worst-performing alternative category (that honor went to managed futures), on average these funds earned less than 0.2%, and about half of that return came from holding cash (three-month Treasuries earned 0.1%).
After the category's negative 0.3% decline in 2011, investors seem to have lost hope in market-neutral mutual fund strategies. (Equity market-neutral hedge funds in Morningstar's database also experienced net redemptions in 2012 through November, but diversified arbitrage hedge funds received substantial inflows). But the fact that two of Morningstar's Alternative Fund Manager of the Year nominations, TFS Market Neutral TFSMX and Calamos Market Neutral CVSIX, came from the market-neutral category proves that averages can be deceiving. These funds ended 2012 with a bang (up 7.8% and 6.4%, respectively) but have also demonstrated solid long-term track records. (See article). Here are a few more rays of hope.
What differentiates many market-neutral funds from other mutual fund strategies--even other alternative mutual fund strategies--is that virtually all of their return comes from alpha, or management's skill in selecting securities. Market-neutral funds are the closest thing to absolute return that investors can hope for, and absolute return is, of course, very difficult to come by. Even more difficult is to find alpha consistently, year after year. Management at JP Morgan Research Market Neutral JPMNX knows this very well. After losing 7.04% in 2011 (the worst year by far in the fund's 14-year history), the fund came roaring back in 2012, with a 4.5% positive return.
Similarly, in 2012, Highbridge Market Neutral HSKAX landed 1.37% the black. This fund, which launched in late 2007, surprised everyone in 2008 when it gained 9.8%, due to its higher-quality stock leaning, but then scared investors away when it lost money in each of the next three years (the fund lost $2.6 billion from outflows). Those that sat tight may be headed for a rebound. The key to holding these types of strategies is diversification, as it is highly unlikely that any one market-neutral manager or strategy will always outperform.
2012 was a good year for merger arbitrage strategies. Touchstone Merger Arbitrage TMGAX, Merger Fund MERFX, and AQR Diversified Arbitrage ADAIX returned 4.3%, 3.6%, and 3.0%, respectively. Although Ernst & Young reported a 10% decline in the number of deals between 2011 and 2012, both in the U.S. and abroad, certain sectors showed particular strength, such as health care. Industry reports cite the presence of private equity firms looking to deploy cash as a catalyst for the strategy in 2013.
Kellner Merger GAKIX is the latest entrant into the merger arbitrage mutual fund space. Launched in June of last year, this fund is run by George Kellner, who has managed merger arbitrage strategies in hedge funds for 30 years. Touchstone Merger Arbitrage, which launched in August of 2011, is also run by a hedge fund firm, Longfellow Investment Management.
New merger arbitrage options should be welcomed by investors, who have been crowding into two of the oldest funds in the category, Merger MERFX and Arbitrage ARBFX. Merger peaked at $5 billion in 2011, and although it lost some assets in 2012 (currently $4.3 billion) it's still twice as large as it ever was prior to 2010. Arbitrage, which follows a smaller-cap strategy, sits at about $3 billion, $2 billion of which it received in the last three years. In 2012, it returned 0.3%, significantly less than in the previous three years. Investors should be highly concerned about capacity constraints in merger arbitrage mutual funds.
At least investors in the Arbitrage fund are benefiting from the fund's major asset expansion. Fees have dropped from 1.52% in 2011 to 1.44% in 2012 for the retail share class. Not only is this fee level low (the average fund in the category charges 1.79%), the advisor to this fund, Water Island Capital, is one of the only alternative fund managers to offer asset-level breakpoints on its management fee. For advisors with more assets to invest, there are even cheaper options. For $3 million, JP Morgan Research Market Neutral JPMNX, for example, charges 0.99%, par with some bond funds.
Investors should look to the market-neutral category to diversify their bond holdings. While high yield and high duration has worked for most bond funds since 2008, credit and interest rate volatility is sure to return. A good market-neutral fund will not only produce positive returns over time, but will do so regardless of stock or bond returns.