Below is a weekly update from our Chief Investment Officer, Dr. Scott Lummer. He co-hosts an audio segment entitled “Market Matters.” In this week's show, Scott discusses market neutral investments. He explains what they are, how they are expected to perform, and why they have had disappointing results. Each week he covers a different piece of investment news focusing on recent events in the capital markets, and relates them to Savant Investment Group’s perspective on investing.
Daphne: Welcome to Market Matters, a weekly discussion about investing in today’s capital markets. I’m Daphne Feng and, as always, I’m joined by the Chief Investment Officer of Savant Investment Group, Dr. Scott Lummer. Scott, this week I want to talk about a question that comes from one of our clients.
Scott: I’d much rather talk about hypothetical questions instead of concerns that people actually have.
Daphne: I’m sure you would. Nonetheless, this question is about market neutral funds – our client wants to know why Savant typically does not recommend them. But to start, please explain what a market neutral strategy is.
Scott: The idea of a market neutral investment is one that has returns that are independent of the market. Whether the U.S. stocks market increases or decreases in value should have no impact on the returns of the market neutral fund.
Daphne: Why is that an important factor?
Scott: We’ve talked a lot about diversification in the past. The lower the correlation between an investment and the rest or your portfolio, the better it is for diversification purposes.
Daphne: What types of investments are market neutral?
Scott: The only natural market neutral investments are cash instruments, such as Treasury bills or money market funds. Whether the market goes up or market goes down, investors earn the same return.
Daphne: But money markets have very low returns.
Scott: You’re right. That’s why investment managers try to create strategies that provide artificial market neutral investments that, if their strategy works, will provide good returns that are still uncorrelated with the market.
Daphne: What are some of those strategies?
Scott: They typically are either long-short strategies, in which the fund buys some securities and short-sells others, or other hedges in which the manager buys securities and sells futures on the underlying market. If the purchased securities increase in value by more than either the short-sold securities or the overall market, the strategy will make money, regardless of whether the market went up or down.
Daphne: So they sound like a good idea.
Scott: In theory, yes they are. But they depend on two things – the manager correctly identifying the securities that will go up in value, and the hedge working well to remove market risk. Recognize that anytime a hedge such as short-sells or futures is used, leverage is created, which adds risk to the strategy. If the purchased securities decline in value, the returns to investors can be disastrous.
Daphne: How have they performed?
Scott: When it comes to mutual funds, not that well. There are three market neutral funds that have a reasonable minimum investment, sufficient size and a 10 year track record. As a group their returns are relatively low, less than 3%.
Daphne: That’s not that bad considering that the natural uncorrelated investment is cash.
Scott: Ah, but as Hamlet said, there’s the rub. It turns out that all the market neutral funds aren’t really market neutral – they all have a relatively high correlation with stocks. So they all earn low returns, but really have not reduced overall portfolio risk.
Daphne: So how can an investor reduce the risk of a portfolio?
Scott: The answer is really right under our nose. Bonds have actually been negatively correlated with stocks since the turn of the century, so they do an excellent job of reducing portfolio risk. And bond returns have been much higher than supposed market neutral investments.
Daphne: That brings me to a question about bonds, but we’re out of time. That’s Market Matters for this week. Thanks to all of you for listening. Please join us next week when I will make Scott apologize for something he wrote 15 years ago.