Jason Kephart: Market neutral funds are some of the most misunderstood funds we cover here at Morningstar. These funds make an equal number of long and short bets on stocks to isolate a manager's ability to pick either individual companies or sectors. By going equally long and short, the fund's net exposure to stock should be 0%. That means when stocks are going up or down, that shouldn't really affect whether these strategies are making money or not. That makes them a pretty good diversifier.
Since the funds do have 0% exposure to stocks, though, a benchmark like the S&P 500 doesn't really make sense. Instead, investors should compare these funds to something like a short-term bond fund or an intermediate-term bond index, like the Barclays Aggregate Index.
The biggest challenge these funds face is their high expense ratios. The average fund in the category charges 1.66%; that's a really high hurdle for a fund whose historical returns look more like a short-term bond fund than a stock fund.
There are a couple of good funds in the category, however. We like Vanguard Market Neutral, which charges 25 basis points, and BlackRock Global Long/Short Equity, which charges 1.60%. Both these funds have proven they can outperform after their expense ratio. They both have Morningstar Analyst Ratings of Bronze.