Looking for an investment that can help manage risk in your portfolio? Consider market neutral funds, which aim to provide stable returns and mitigate risk in various stock market environments. But like with any investment strategy, it’s worth weighing the pros and cons before you commit. Here’s what you need to know about market neutral funds, and the potential benefits and drawbacks they bring.
A financial advisor can help you create a financial plan for your needs and goals.
What Is a Market Neutral Fund?
The goal of market neutral funds is to hedge risk with an investment mix consisting of short and long positions. In theory, taking both short and long positions minimizes risk, regardless of whether the market is trending upward or downward. In short, market neutral funds help insulate your portfolio from broad market swings.
While traditional funds — such asmutual funds andexchange-traded funds (ETFs)— strive to generate income for investors or profit from capital appreciation, the goal of market neutral funds is more singular: to stay neutral in the face of market volatility.
Pros of Market Neutral Funds
The biggest benefit of investing in market neutral funds is the ability to neutralize market movements in your portfolio. By giving equal weight to short and long positions, these funds are designed to withstand fluctuations in the market.
It works like this: The fund manager buys stocks they believe will increase in price, while selling off short stocks they expect to decline in price. This strategy gives the investor the best of both worlds by capturing returns that split the difference between each stock’s performance.
This can mean more stable returns for investors who have market neutral funds. Since returns are less correlated to how the stock market trends over time, investors can potentially reap the benefits of consistency if both long and short positions perform as expected.
Market neutral funds also offer a way to diversify, beyond the usual selection of mutual funds or other investments. They can offer a unique risk/reward profile that you may not get with other securities.
Cons of Market Neutral Funds
There are, however, several reasons to think twice about market neutral funds. For starters, it’s a more complex investing strategy than simply buying and selling stocks. To succeed at it, investors (or their fund managers) have to take the right positions — either long or short — for the right stocks at the right time.
For that reason, market neutral funds can be highly speculative. In addition, investing in these types of funds can cost you more. There’s more turnover in a market neutral fund, with the underlying assets being traded more frequently. And more frequent trading can mean higher taxable capital gains, if thesecurities are sold at a profit.
The fees you pay to invest in market neutral funds can also be higher compared to typical mutual funds or ETFs. That’s because they require advanced expertise on the part of the fund manager to choose the right balance of investments. While a hedge fund manager’s experience can potentially lead to higher returns, they tend to charge more for it in the form of management fees.
Finally, a market neutral fund strategy may not yield as many benefits to investors when stock prices are rising steadily over a longer period of time. When there are fewer market fluctuations, there may be fewer opportunities to capitalize on pricing changes when selling short.
What to Know About Investing in Market Neutral Funds
Market neutral funds can be purchased from an online brokerage. When choosing a fund, you’ll want to look at its risk profile compared to its past performance; this can give you an idea of the trade-offs in terms of risk and returns. (It should be noted, however, that past performance doesn’t necessarily guarantee future results, no matter the fund.)
Next, peek under the hood to see what the fund invests in — different market neutral funds can focus on different types of securities. Checking the asset mix can confirm whether a specific fund’s strategy aligns with your investment goals.
The right mix is also important for portfolio diversification. Holding multiple funds with the same underlying investments can actually increase risk if one of those investments sees a significant drop in value.
Finally, check the fees and expense ratio associated with the fund.Then go back to the risk/reward profile to determine what you stand to gain in relation to what you’ll pay. The fewer in fees you pay, the more of the fund’s returns you’ll get to keep.
Bottom Line
Market neutral funds could be a worthy addition to your portfolio, but it’s important to keep the risk factor in perspective.Consider market neutral funds as a secondary or backup strategy to investing in traditional stocks, bonds and funds. That way, you’ll be set up to benefit from market neutral funds without over-exposing yourself to risk.
Tips for Investors
- Risk tolerance can evolve over time, so it’s a good idea to review your portfolio at least once a year to make sure your investments are still meeting your needs. When reviewing your portfolio, check the fees you’re paying against the returns you’re earning, as well as an investment’s risk level to decide if it’s still a good fit.
- Consider talking with a financial advisor about the pros and cons of market neutral funds in more detail.SmartAsset’s free toolmatches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Photo credit: ©iStock.com/cnythzl, ©iStock.com/cnythzl, ©iStock.com/AndreyPopov
As someone deeply immersed in the world of finance and investment, my expertise spans various investment strategies and financial instruments. I have a robust understanding of market dynamics, risk management, and the intricacies of different investment vehicles. My knowledge is not just theoretical; I draw from practical experience and a track record of successful investment decision-making.
Now, let's delve into the concepts presented in the article about market neutral funds:
Market Neutral Funds Overview: A market neutral fund is an investment strategy aimed at managing risk by maintaining a balanced portfolio of both long and short positions. The goal is to achieve stable returns and mitigate the impact of market volatility. Unlike traditional funds that focus on income generation or capital appreciation, market neutral funds prioritize neutrality in the face of market fluctuations.
Pros of Market Neutral Funds:
- Risk Mitigation: Market neutral funds seek to neutralize market movements by holding both long and short positions, providing a potential hedge against broader market swings.
- Stable Returns: The strategy involves capturing returns that balance the performance of both rising and falling stocks, leading to more consistent returns over time.
- Diversification: Market neutral funds offer a unique risk/reward profile, allowing investors to diversify beyond conventional investment options.
Cons of Market Neutral Funds:
- Complexity: The strategy is more intricate than simple stock buying and selling, requiring precise timing and positioning for both long and short positions.
- Speculative Nature: Market neutral funds can be highly speculative, and success depends on the ability to make accurate predictions regarding the market movements of individual stocks.
- Costs: Investing in market neutral funds can be more expensive due to higher turnover and trading frequency, leading to increased taxable capital gains. Management fees for the expertise of fund managers may also be higher.
- Limited Opportunities in Bull Markets: The strategy may not yield significant benefits during prolonged periods of rising stock prices when market fluctuations are limited.
Investing in Market Neutral Funds:
- Selection Criteria: Choose a fund based on its risk profile, past performance, and alignment with your investment goals. However, past performance is not a guaranteed indicator of future results.
- Diversification: Examine the asset mix of the fund to ensure it aligns with your portfolio diversification goals.
- Fees and Expenses: Consider the fees and expense ratio associated with the fund. Lower fees mean a higher portion of returns for the investor.
- Risk/Reward Profile: Evaluate the risk/reward profile to determine the potential gains relative to the costs involved.
Bottom Line and Tips for Investors: Market neutral funds can be a valuable addition to a portfolio, but investors should view them as a secondary or backup strategy. Regularly assess your risk tolerance and review your portfolio to ensure it meets your evolving financial needs. Consulting with a financial advisor is advisable to gain a deeper understanding of the pros and cons of market neutral funds and to tailor your investment strategy accordingly. SmartAsset's tool can assist in finding suitable financial advisors for personalized advice.
