We currently stand at 64 months and counting in this current bull market. The third longest bull market since 1930, behind only the bull runs of 1949-1956 and 1990-2000. The 1949-1956 bull run was brought by the “Greatest Generation” finally starting families and entering into the prime earning years of their careers.
The 1990-2000 bull run was the result of the collapse of the Soviet Union, bringing the U.S. to worldwide dominance. It was also the result of the growth of computing technologies throughout the 1990s. I don’t want to get into the controversy regarding the cause of this current run, but the Federal Reserve’s stimulus has certainly played a major part.
So the question at hand is can this bull market continue its epic run? While every analyst has their opinion, the fact remains, no one knows for sure. The only certainty is that all good things must come to an end, and no one wants to be all in at the end.
That is why if you are heavily invested in this market continuing its run, it might be best to start thinking of ways to diversify your portfolio so you aren’t relying too much on the bull market continuing. One of those options, which hasn’t had much hype but might be a great choice, are market neutral funds.
What are Market Neutral Funds?
With market neutral funds, it doesn’t matter if this bull market continues or not, they can still find success due to the hedging strategy they implement. Market neutral funds in their most basic construction are usually formed by choosing specific sectors or industries and going long in undervalued securities while going short in overvalued securities.
For this strategy to work it is important to have a fund manager who is skilled at finding undervalued, as well as overvalued, securities. If this is done correctly, the fund can find success regardless of the sector or industry performing well or not. This is because if the sector or industry is performing well, the undervalued securities should have price increases greater than the overvalued securities. Thereby the gains in the undervalued long positions should be greater than the losses in the overvalued short positions.
On the opposite side of things, if the sector or industry performs poorly, the securities that are overvalued will take greater price hits than the undervalued securities. This will lead to gains in the short positions that are larger than the losses in the long positions.
Success Not Guaranteed
To be successful in this strategy is not as simple as just correctly choosing the right undervalued and overvalued securities. The fund manager needs to be sure to keep the value of the short and long positions balanced in investing dollars, which is called dollar neutral, as well as, trying to keep the basket of securities as close to beta neutral as possible.
This is accomplished by keeping the beta on the short side the same as the beta on the long side, thereby making the beta of the portfolio zero. This is all in theory, as it is almost impossible to keep a portfolio constantly at a zero beta.
For those who are not familiar with beta, it is a measure of the systematic risk, or volatility of a security or a portfolio in comparison to the overall market. A security or a portfolio with a beta of 1 will move with the market. A security or portfolio with a beta of 1.2, is theoretically 20% more volatile than the market, while a beta of .8 would be 20% less volatile than the market.
Thereby a beta of zero means that the security or portfolio would have no correlation with the market and have the same expected return as the risk-free rate. This all seems like a lot of work, when you could just invest in risk-free, short term securities to achieve the same beta of zero. However, with some skilled securities picking, beating the return of a risk-free rate is possible as the managers of market neutral funds have shown in the past.
Market Neutral Funds to Buy
Since there are currently only four market neutral funds with a top Zacks Mutual Fund Rank, I have chosen to list one Zacks #1 and one Zacks #2. This is due in part to one of the funds having a $5,000,000 dollar minimum initial investment, while the other fund’s head manager departed the company at the end of June. To view the Zacks Rank and past performance of all market neutral funds, investors can click here to see the complete list of funds.
The first Zacks #1 Rank (Strong Buy) market neutral fund to buy is Virtus Dynamic AlphaSector Fund Class A (EMNAX). The fund’s investment objective is long-term capital appreciation, achieved by taking long and short positions in ETFs and/or stocks representing the nine primary sectors of the S&P 500 Index. The Virtus Dynamic AlphaSector Fund Class A utilizes a proprietary quantitative model that seeks to evaluate price trends within each sector, while eliminating fluctuations in price and volume in the market that can confuse interpretations of market direction.
This market neutral fund has a one year return of 22.77%, and a load adjusted return of 16.09% as of June 30, 2014. The five year return is an annualized 6.91% and a load adjusted return of 5.72% as of June 30, 2014. It also has an affordable $2,500 minimum initial investment, compared to other #1 funds in this category that could be as high as $5,000,000.
The Zacks #2 Rank (Buy) market neutral fund to buy is American Century Equity Market Neutral A (ALIAX). The objective of the fund is long-term capital appreciation independent of equity market conditions. The American Century Equity Market Neutral A fund seeks to achieve this objective by investing mainly in the 1,500 largest publicly traded companies in the United States. The sectors most heavily invested in are consumer discretionary, industrials, information technology, and financials.
This market neutral fund has a one year return of 3.96%, and a load adjusted return of -1.69% as of June 30, 2014. The five year performance is an annualized return of 2.08% and a load adjusted return of .94% as of June 30, 2014. It also has an affordable $2,500 minimum initial investment.
Other Alternatives Available
Market neutral is just one category of many mutual funds categories listed on Zacks where performance isn’t strongly hinged to the continuation of the bull market. Other categories include China - Equity, Diversified Bonds, Europe - Equity, Mortgage Bonds, Non US - Equity, and International - Bonds. To view the Zacks Rank and past performance of all Zacks #1 Ranked funds, investors can click here to see the complete list.
About Zacks Mutual Fund Rank
By applying the Zacks Rank to mutual funds, investors can find funds that not only outpaced the market in the past, but ones expected to outperform going forward. Learn more about the Zacks Mutual Fund Rank in our Mutual Fund Center.
Read the analyst report on EMNAX
Read the analyst report on ALIAX
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