Market Neutral: The Last Path To Diversification
Much of the recent growth in international stocks, commodities, and REITs is driven by the need to diversify portfolios. Unfortunately, this past downturn has shown that effective diversification cannot be achieved by just adding a few more assets. When markets decline, people sell everything because they need to raise cash to cover losses. In today’s market, people are selling their art, their wine, and any other asset they can liquidate.
The only way remaining to get a true market neutral investment is to hold a long-short position. The long position holds stocks that do better than the overall market and the short position holds stocks that will do worse. If the markets crash, a portfolio can still make money, so long as the long stocks do better than the short ones. Or if every stock falls equally, the portfolio simply breaks even.
If investors don’t want to go through the effort of picking stocks and ranking them, they can instead rely upon the academic research and find numerous factors that have historically offered superior returns. Here are three: size (small beats large), value (value beats growth), and momentum (stocks with upward trends beat those with downward trends). While none of these factors guarantees that a stock will outperform its peers, each one provides a statistical advantage.
Although a market neutral fund can be built with stocks on margin, the most efficient way to do so is with derivatives like futures and options, especially with liquid indexes and a low interest rate environment. For example you can buy Russell 2000 futures and sell S&P 100 futures to get the size premium with minimal margin and almost zero cost. Selling options can also provide a fourth factor, a volatility premium. The easiest way to get this factor is to sell both at the money call and a put simultaneously which creates a short straddle.
Using derivatives, investors can also apply leverage to any or all of these factors and boost returns. For example, a S&P 500 call writing strategy beats the S&P 500 alone with less risk because it’s the combination of two offsetting factors, the equity premium and the volatility premium. The volatility premium also rises when markets fall and this helps portfolios recover their losses more quickly after a crash.
Just adding leverage to a simple covered call strategy creates an investment that historically outperforms the S&P 500 while maintaining the same risk level. Of course when using leverage, the reinvestment strategy is crucial – the poor performance of leveraged ETFs shows how the wrong reinvestment strategy can dig a portfolio into a deep hole. And any leveraged position should be hedged to insure against catastrophic losses.
Investors assume that to get these kinds of advanced investment strategies, they have to go to hedge funds, which means giving up transparency and liquidity, paying higher fees, and taking chances outside the regulatory framework. In today’s fearful investment environment, nobody is going to take the risk of not being able to access funds when they need to or perhaps losing them altogether due to fraud just for the promise of a more diversified return.
However there are market neutral funds out there that offer the same benefits, just about 50 or so. The problem is that many, perhaps most of them, aren’t very good. They have low returns, recent losses, correlations with the S&P 500, and significant fees. And those few that have performed well don’t don’t offer enough transparency for an investor to be sure that the positive returns will continue. There’s a lot of room for improvement in the sector.
Still, multi-factor, market-neutral investing may be the best growth opportunity for money managers in the industry today. Diversification may be more difficult to get, but it is more needed than ever. Someday soon, virtually every investor could have 25% of their retirement portfolio in a market neutral fund as part of an asset allocation and rebalancing strategy, representing trillions of dollars of collective assets.
Before that happens, there needs to be a revolution in transparency. At this point, most hedge funds and market neutral funds are “black boxes” and it’s impossible to know with any certainty how the fund is managed or often even what its strategy is. Investors are expected to have faith in management but given little in return.
Instead, market neutral funds need to publish and share their strategies, just as index investors do. That approach helps encourage debate and discussion, which in turn builds an audience and fosters trust with investors. And over time, this leads to more varied and better products. It’s an “open source” approach to investing that has helped rapidly grow the ETF market.
If portfolio managers are concerned that by sharing their work they’re giving away the goose that lays the golden eggs, consider this: While the largest hedge funds have tens of billions of dollars under management, Vanguard still has almost a trillion. John Bogle’s lifelong commitment to advocacy and openness has made him one hundred times more successful.
This is echoed by my own experience researching and publishing indexing-related futures & options strategies and exchanging ideas with readers. Investors are not looking for gurus that know all but share little and treat them like mushrooms. Instead, they want mentors that can frame problems and discuss many possible solutions while still respecting both their ability to learn and their freedom to make their own choices.
Still, while the markets fall and the fund industry drags its heels, the research and tools are there for investors to develop and construct their own market neutral and hedged investments in order to diversify effectively, and more and more are doing so. Expect even more new approaches to portfolio management emerge, as the usual response to economic adversity is ultimately greater innovation and creativity, fortunately.
Tristan Yates is the author of the book Enhanced Indexing Strategies and his articles and research on investing have been distributed through Yahoo! Finance, Forbes, MSN, Investopedia, Kiplinger, and Futures & Options Trader and cited in The Wall Street Journal and Globe & Mail. He can be reached at tristan@indexroll.com.