Why I Wouldn't Invest In Market Neutral Funds

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Park
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Why I Wouldn't Invest In Market Neutral Funds

Post by Park »

http://beta.morningstar.com/articles/83 ... or-li.html

"investors buy alternative funds for diversification, or, more specifically, for their low correlations to equities and bonds and potential alpha...alpha and low correlations are hard for managers to provide"

When it comes to alpha, often an investor buys alternative funds to access unique or uncorrelated alpha. One such source of unique alpha is shorting.

http://beta.morningstar.com/articles/84 ... -2017.html

Vanguard has a market neutral fund.

"its annual turnover of 64% is one of the lowest turnover rates in the market-neutral category, which gives it another cost advantage since frequent trading can turn into a lot of trading costs. The average market-neutral fund had 250% turnover...

This fund sports the cheapest price tag of any alternative mutual fund. The fund's institutional shares have an annual report net expense ratio of 0.14%. The median expense ratio of a similarly distributed share class is 1.50%. The retail shares charge 0.22%. The retail share class should be taken with a grain of salt, however, as it has a $250,000 minimum investment...

It's worth noting that Vanguard displays the retail share class' net expense ratio as 1.60% on its website. That figure includes the cost of shorting, which Morningstar does not include in its calculation of the annual report expense ratio since it is considered a brokerage cost...

since Vanguard took over sole management of the fund in late 2010. From that point, the fund's 2.8% annualized return and 0.57 Sharpe ratio landed in the top third of the category as of the end of 2017." The Vanguard market neutral fund lost 4.8% in 2017.

In a market neutral fund, there should be no return from beta. With a 1.6% headwind due to shorting costs, turnover etc and no beta exposure, that 2.8% annualized return is very good. So you've accessed some alpha with little correlation to the market.

From what I can see, a market neutral fund is a cash substitute. How would you have done in a HISA during the same time period? Right now, EQ Bank is offering 2.3%. I don't have data for HISA from late 2010 to the end of 2017, but I wouldn't be surprised if the top HISAs gave Vanguard's market neutral fund a run for its money. Admittedly, you'd probably have to move your money between banks to get the optimal rate, but that's certainly a much simpler strategy than a market neutral one. You'd have little correlation to the market with likely similar return.

The following is a bit of a tangent. The cost of shorting is a high hurdle for market neutral and long short strategies to overcome. I've seen good arguments made for shorting. But those have been to use shorting to manage risk, and the shorting is against stock indices, rather than individual stocks. The cost of shorting stock indices tends to be less than that of individual stocks.
Park
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Joined: 13 Aug 2010 20:51

Re: Why I Wouldn't Invest In Market Neutral Funds

Post by Park »

I'd prefer not to bump my own thread, but it's past the time limit where I can edit the original post. The following links from Fama and French should be read by anyone considering a market neutral strategy or a long short strategy:

http://citeseerx.ist.psu.edu/viewdoc/do ... 1&type=pdf

https://famafrench.dimensional.com/essa ... egies.aspx
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