July 14, 2013

Are the higher fees and lower returns of market-neutral funds insurmountable obstacles to their purchase?

by andrew.clark.

It has been noted in many articles and by the Financial Industry Regulatory Authority (FINRA) that market-neutral funds tend to have significant portfolio-turnover risk, which can result in higher costs for investors. In terms of operating expenses alternative investment mutual funds can be pricey relative to their traditionally managed fund peers. It is common for alternative funds to have annual operating expenses of around 1.5%, and some funds are considerably more expensive.

Are the typically higher fees for market-neutral funds the only obstacle to their purchase? Market-neutral funds have returned only 1.7% on average on an annualized basis over the past five years—substantially below the average annual return of U.S. domestic equity (USDE) funds over the same period—between 9.4% and 14.4% based on classification (Lipper’s USDE groupings include the large-cap, mid-cap, small-cap, and multi-cap versions of core, growth, and value equity funds). So, market-neutral funds are more expensive—typically 20 basis points or more—than USDE funds, and they have returned substantially less than USDE funds over the past five years.

However, as has been noted by Lipper in earlier articles about alternative funds, we view them as primarily diversifiers (of risk) and not necessarily as return enhancers. The risk-return picture of market-neutral funds in most cases is substantially better than that of all but one or two USDE classifications.

REUTERS/Carlos Barria

REUTERS/Carlos Barria

Using downside deviations and maximum drawdown as initial measures of risk, market-neutral funds have a fifth or less risk in terms of downside deviation than do all USDE fund groupings and a 25% to nearly 100% better maximum drawdown. The only two USDE fund groups that have equivalent maximum drawdown numbers are small-cap core funds and small-cap value funds.

Similar results hold for the Sharpe, Sortino, and upside potential ratios. For all USDE fund groups it is only in the three small-cap groupings (core, growth, and value) where the 0.47 annualized Sharpe ratio of market-neutral funds meets any competition. The same holds for Sortino ratios. As for upside potential, given the large discrepancy in the annualized returns between market-neutral funds and USDE funds, all of the USDE fund groupings have substantially greater upside potential ratios.

We offer the reader an alternative view of market-neutral funds: Do not look just at their nonrisk-adjusted returns or their fees but rather at what they can add in terms of diversifying the risk of a portfolio. Given the superior risk-adjusted performance of market-neutral funds, any investor concerned about risk would benefit by taking a close look at market-neutral funds. Market-neutral funds more than likely will reduce nonrisk-adjusted return in good markets, but they can very well protect returns in down markets.

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