Low correlation is the appeal of market-neutral funds.
Market-neutral funds isolate return from a manager's skill by hedging out exposure to broad market movements. The remaining return comes from picking stocks long and short (equity-market neutral), selecting the most profitable merger deals, or seeking mispriced convertible securities. Just as the many long-only managers who struggle to add value relative to their benchmark, market-neutral funds endeavor to outperform their benchmark, which is typically cash. The average market-neutral equity fund returned 0.50% in the first half of 2013 and 0.20% in 2012, versus 0.05% and 0.08% for cash over the respective time periods. Further, the average fund in the category lost 1.0% over the past five years and generated only 0.8% over the past 10 years ending in June 2013, compared with 0.3% and 1.7% for cash, respectively. (Only nine of the 42 market-neutral funds had a 10-year track record, however.)
Despite the paltry returns of the category average, there are several standouts. The best performers over the past 10 years have been arbitrage strategies: Gabelli ABC AAA GABCX, Silver-rated Merger MERFX, Bronze-rated Arbitrage ARBFX, and Bronze-rated Calamos Market Neutral Income CVSIX turned in annualized returns of 4.6%, 3.7%, 3.7%, and 3.5%, respectively--well above the return of 1.7% for cash held over the same period. Gold-rated TFS Market Neutral TFSMX doesn't have a 10-year track record, but it returned 2.7% over the past five years by taking long and short positions in stocks based on nine different quantitative factor models, compared with 0.27% for cash.
Even modest returns can improve the risk-adjusted returns of a typical investor's portfolio, because of their low correlations. Over the five years ended June 2013, the market-neutral category has exhibited a correlation of 0.06 to the S&P 500 and 0.27 to the Barclays U.S. Aggregate Total Return Bond Index. As a result, investors added $2.1 billion to market-neutral funds in first five months of 2013.