Add a Market Neutral Strategy

The 1990s saw one of the greatest bull markets in history. This also ushered in the popularity of long-only investments like mutual funds, unit investment trusts and, to a certain extent, separately-managed accounts (non-pooled money managers). Through these vehicles, investors and/or their advisors were able to achieve diversification by using asset allocation through modern portfolio theory (MPT).

The bear market of 2000-2002 and the most recent downturn of nearly 20% - from the top of the market in October 2007 to the first quarter of 2008 - taught us all a valuable lesson. In a market that is stressed, or one that suffers unpredictable shocks, most asset classes are correlated. In plain English, all these different assets' prices went down. Globalization also plays a role in the changing correlations between asset classes. We must now look at alternatives in order to reduce the overall risk of your portfolio.

What do we invest in?

One solution can be found with alternative investment strategies. Alternative investments offer diversification possibilities that traditional long-only investments are unable to provide. They come in all shapes and sizes these days. What was once only available to investors who could handle high minimum investments, today are becoming part of the investment mainstream. There are traditional hedge funds, hedge strategies and even mutual funds that use the same techniques that hedge funds use. Today we will focus on what is called a market neutral strategy.

Market Neutral

This is a type of long/short strategy. This type of strategy seeks to generate positive returns in both rising and falling markets. The goal for this strategy is to eliminate both event risk (i.e. sub prime and credit markets crisis) and market risk. Market Neutral may pit one stock against another.

Let's take Zacks ranking system as an example. The money manager may buy our Zacks #1(strong buy) Rank stocks and may choose to short sell (the goal is to sell high and buy back low) the negatively correlated stocks like our Zacks #4(sell) Rank or Zacks #5(strong sell) Rank stocks.

Another example would be buying ABC Chicken and matching that with a short sale of XYZ Beef because the manager hears the news about an occurrence of mad cow disease. The dollar value of the long positions and short positions are equal. This type of strategy is mostly used as a proxy for fixed income and considered an absolute return strategy. This sort of strategy may be appropriate in this interest rate environment. The key to this strategy is that it typically has no correlation to the stock or bond markets. This provides better diversification to traditional asset-allocated portfolios.

What are the fees?

That depends. If you cannot meet the higher minimums of hedge funds (partnership structure) or hedge strategies (separately managed account structure), there are mutual funds you can purchase. You may get load or no load funds, although expense ratios may be higher because of the specialization of this type of investing.

Hedge funds and strategies may charge a percentage of assets (around 1% to 2%) and a performance based fee that is usually based on 20% of your profits. Many firms charge just the performance fee. In this scenario, performance fees are charged only after your investment hits a new high water mark. For example, you invest $1 million and you make 10% or $100,000 for the first quarter. You would pay your manager $20,000 and you keep and reinvest the other $80,000 making your portfolio worth $1,080,000. If your account does not go above $1,080,000 million the following quarter, you don't pay a fee.

Keep in mind that these investments are not for everyone. Many hedge strategies have high minimums and mutual funds may be the better route. Hedge funds and strategies require you to be a qualified investor with at least a $1.5 million net worth.

Are these investments right for you? If you want alternatives to your traditional stock, bond and cash asset allocation, these strategies may be the answer.

Jonas Zamora is a Certified Financial PlannerTM professional. You may contact him at jzamora@zacks.com.

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