How Not To Make a Mutual Fund

No Pain, No Gain
Of all fund types, market-neutral* seems to be the least useful. To be sure, other fund categories are riskier or more gimmicky or more dangerous. Some are all three. For example, the many varieties of leveraged index exchange-traded funds, which not only lurch in price over the short term, but which are also long-term losers because of how their leverage is implemented. However, for brief periods of time, those funds can turn a nifty profit.

[* Market-neutral funds are those that attempt to eliminate their exposure to a market (typically a stock market) by having as much money in short holdings as in long holdings. The idea is that the long and short positions will hedge any market movements, leaving the fund with a net profit (or loss) from the non-market-related movements of its securities.]

What can market-neutral funds do? Certainly not turn a nifty profit. Unlike leveraged ETFs, which move in response to their indexed asset, market-neutral funds by definition are untethered from others' fortunes. The benefit of this freedom is lower risk; the drawback is lower returns. Much lower. Absent manager contribution, the neutral return on a market-neutral fund equals cash minus expenses. That is the fund's beta, to use the nomenclature. Cash minus expenses. It's not much.

In fact, it's less than not much. With cash rates now near zero, and expenses on market-neutral funds averaging a steep 1.80% per year, the neutral return is negative. Well, that's great--a fund with an expected negative return. Where do I sign up?

Yes, this neutral return is supplemented by manager contribution. Let's consider that part. There are no managers of conventional, long-only funds who reliably add several percentage points per year through shrewd security selection. Yet somehow, in the group of market-neutral funds, there are enough such managers to justify the existence of 39 funds. Remember, with a negative-to-flat net return from beta, market-neutral funds need ongoing genius merely to post modestly positive gains.

It sounds simple when I write it that way, doesn't it? It is that simple. There are no hidden mysteries. Here are the average results for market-neutral funds, through June 30, 2013:

To the extent that an argument can be made for the category, it would be for the group's merger-arbitrage funds.  Merger Fund (MERFX) and Arbitrage Fund (ARGAX) have among the group's best 10-year returns at 3.75% and 3.74%, respectively. (Gabelli ABC Fund (GABCX) has been better yet at 4.62%, but it is not a true market-neutral fund.) In addition to their better performance, merger-arbitrage funds have an economic theory as to why their long selections might outperform their shorts; thus, they needn't rely solely on manager brilliance. It's not a strong claim, mind you, given that the cheaper short-term government funds came in at 3% per annum with half the volatility, but at least it's a possible claim.

Otherwise, what can be the logic for selecting a market-neutral fund? Neither the expectations nor the results have been acceptable. Also, it's not as if one can dramatically improve prospects by selecting the lowest-cost funds in the group. Vanguard's Market Neutral Fund (VMNFX) is as expected very cheap, at a 0.25% annual expense ratio. However, it has placed eighth out of 10 market-neutral funds over the past decade. Over that time period, there has been no correlation between expenses and net performance in the (admittedly small) group.

The lesson seems straightforward. ETFs package high beta, low expenses, and low/no alpha. Market-neutral funds do the opposite. Both fund types debuted in the 1990s. Beta and costs are reliable friends. Alpha is not. ETFs got it right and have been rewarded with $2 trillion in assets. Market-neutral funds got it wrong.

 

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.