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The stellar performance of the stock market in recent years has given investors plenty to smile - and worry - about. Nervous investors who expect the tide to turn may seek strategies to reduce exposure to market volatility.
Market-neutral investing is a strategy which seeks to eliminate, or "neutralize," the effects of stock market volatility - both upward and downward movements - on portfolio performance. It involves investing in a portfolio of undervalued stocks while short-selling overvalued stocks. In a declining market, the short positions should generate positive returns, while the long positions may lose. In a rising market, the short positions may suffer losses, while the long positions gain ground.
What's more, market-neutral investing essentially creates a new asset class that is not correlated with stocks or other asset classes, so it can bring an extra level of diversification to an investment portfolio.
Market-Neutral Mutual Funds Make Their Debut
Until recently, investors who wanted to take advantage of short positions in stocks had to choose between short selling individual securities on their own or investing in a hedge fund. (Note: Individual's must have more than $5 million in investments to "qualify" to invest in a hedge fund, according to the National Securities Markets Improvements Act of 1996.) Mutual funds were significantly limited in their ability to short sell. Under the "short-short" rule, mutual funds could not generate more than 30 percent of their income from short-term gains, including gains from securities held for 91 days or less, derivatives, and short-sales for any length of time.
The Taxpayer Relief Act of 1997 repealed the short-short rule, and one result has been the introduction of mutual funds that may sell short as part of a market-neutral strategy.
Stock Selection Is Critical
Market-neutral investing can offer positive return potential in two ways. First, the capital appreciation plus dividends received on the portfolio of stocks purchased represent the return potential of the long positions. Second, the depreciation in value of stocks sold short plus any income from the reinvestment of the sales proceeds minus the transaction costs of the short positions produce additional return potential.
A great deal of the potential success of a market-neutral portfolio depends on prudent selection of undervalued and overvalued stocks, and the symmetry between the long and short positions. The fund manager needs to be highly skilled at selecting undervalued stocks to buy and overvalued stocks to sell short. He or she also must strive to build a portfolio in which long positions and short positions have similar exposures to all sources of volatility, including not only market movements but also interest-rate fluctuations, changes in each industry's health, and more.
An Added Level of Diversification
A market-neutral mutual fund might make sense as a complement to a well-diversified investment plan of stocks and fixed-income securities. Because market-neutral investing involves investing in stocks, it may offer greater return potential than fixed-income securities. And because it combines long and short positions in stocks, it may be less volatile than stocks and provide downside protection in declining markets.
A Strategy Not Without Risks
Of course, market-neutral investing also creates exposure to losses due to the depreciation in value of long positions and/or appreciation in value of short positions. Poor stock selections (for investment, short sales or both) or mismatching the exposure of either the long or short positions could hurt the portfolio's overall results.
Also, keep in mind that while market-neutral investing may help reduce volatility during a fluctuating market and reduce potential losses in a declining market, it also may offer lower return potential than stocks along (with no short sales) in a rising market.
Because the materials covered in this article are complicated, this article should not be regarded as offering a complete explanation and should not be used for making decisions. Any suggestion should be reviewed with your personal financial and tax advisor.