Jan 19

“Market Neutral Strategies as part of the Equity Allocation”…huh???

I read the following comment this morning in the Money Management daily enews…Market Neutral Funds Underrated: Zenith

There is demonstrable portfolio improvement to be had from allocating to market neutral strategies as part of the equity allocation…

That says to me that if you want to improve your equities part of the portfolio then replace part of it with something that is not equities; or, if you want to improve your equities portfolio then diversify away from equities; or even more cynically, because equities have performed badly you should not have invested in equities and had some market neutral investments.

You see, if an investment is market neutral then its net exposure to the market, by definition is basically zero…or a market beta of zero. For example, if I invest $100,000 in my best stock ideas from the ASX200 and then short the ASX200 index by $100,000, my net exposure to the market is zero and therefore market neutral. I then take my $100,000 and invest it in something conservative like a portfolio of cash-like investments and the return I receive is a cash-like return plus the outperformance (or underperformance) of my best stock ideas.

So, as you can see, my return is not at all equity-like because my return equals cash plus alpha minus fees…which, given the fees are typically very high and over the long run alpha does not often outperform fees, means my long run return will probably be less than cash…but this is still a better return than shares over the last 4 years!!!

OK, believe it or not I don’t mean to suggest that market neutral strategies should never be part of an investment portfolio. Just that they carry is a very different type of risk than equities. So the decision to include market neutral strategies in a portfolio means there must firstly be a non-traditional approach to the asset allocation decision (i.e. the inclusion of “alternatives”) and therefore there must be a decision made as to which traditional beta risks must be exchanged for this market neutral strategy…I’m sure it will often be equities but it could equally likely be credit risk, property, or even other so-called alternatives such as commodities or private equity etc.

In the article there were a few funds mentioned that Zenith reviewed and some of them with quite good recent performance. Blackrock’s Market Neutral fund returned 28% over the last 12 months so there’s every chance both longs and shorts did reasonably well…as opposed to my example, Blackrock short stocks as opposed to the index as a whole. Despite that great performance it was quite muted in 2010, and underperformed shares in 2009. Market Neutral funds do have the ability to provide good returns but always keep in mind those returns are purely reliant upon manager skill.

My final comment relates to Zenith’s view on fees…

The idea that overall returns will be improved by reducing input costs relates more to industries such as manufacturing but doesn’t apply to something like funds management where there is intellectual property involved – so it doesn’t make sense to look at the MER rather than the net returns.

…and its something I strongly disagree with. With the failure of so many active managers to outperform their benchmark and not deliver on their promises, the easiest way to increase your return is with low fees. Hedge funds were found out over 2007 and 2008 and 2 and 20 has largely disappeared. Successful Funds management is very difficult and if you are good you will be rewarded with strong inflows and strong inflows can still fill the pockets of the greedy fund manager with more money than they’ll ever need…Ill save my rant on performance fees for another day.



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