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The Market Neutral Fantasy

“I like nonsense, it wakes up the brain cells. Fantasy is a necessary ingredient in living.” –Dr. Seuss

Fantasy may be a necessary ingredient in living, but in choosing investments it can be perilous.

The biggest fantasy in the world of investing is the Market Neutral strategy. Market Neutral is the fanciful idea that there is a certain class of funds which can be perfectly hedged from market risk, generating returns purely from alpha. They also promise significantly lower volatility and no correlation to traditional stock indices.

“Sounds great, I’m wiring the money now,” said many an institutional investor over the years.

And what have Market Neutral funds done for their investors over the past 15 years? In a word: nothing.

The HFRX Market Neutral Index has a total cumulative return of 3.0% over the past 15 years versus a 124% gain for the S&P 500.

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The hedge fund true believers will argue that it’s not just about return. The Market Neutral Index had a -.01 monthly correlation with the S&P 500 over this period with only 3.6% annualized volatility and a maximum drawdown of 14.9%.

Surely you would want such an exposure in your portfolio, even if it returns nothing, they would say.

I could debate them on that point but as it turns out, I don’t have to. There was another asset class with a -.11 correlation to stocks over this period and 3.5% annualized volatility with a maximum drawdown of only 3.8%.

What is this magical asset class? Simple, boring bonds. The Barclays Aggregate Bond Index returned 107% over the past 15 years while providing the same low correlation and low volatility that Market Neutral funds crow about.

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True, there are no fancy offices or colorful marketing books with bond index funds. There are no high pedigree managers or sumptuous steak dinners. And finally, there is no fantasy of being perfectly hedged.

If that’s what you’re after, you have certainly found what you’re looking for in Market Neutral funds. For everyone else, bonds seem to be the uncorrelated choice more rooted in reality.

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Further Reading:

The Hedge Fund Myth

From Alpha to Beta: A Long/Short Story

This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.

CHARLIE BILELLO, CMT

Charlie-Bilello

Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts.  He is the co-author of four award-winning research papers on market anomalies and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors previously held positions as an Equity and Hedge Fund Analyst at billion dollar alternative investment firms.

Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.

You can follow Charlie on twitter here.

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