The challenges of passive fee-based advice; market neutral funds

In the April 2010 Investment Executive, I touch on some of the challenges that advisors face in transitioning to an index-oriented fee-based business model.  Keep an eye out for my follow-up in the May issue, in which I will outline where advisors can really add value to ETF or index-fund portfolios.

On the other end of the investing spectrum, in this Globe & Mail article, I commented on market neutral (MN) funds and the difficulty of putting the theory into practice.  There is some explanation that couldn’t fit into the article.  In theory, adding MN funds can enhance a portfolio’s risk-return profile.

Investment theory holds that any performance in excess of risk-free alternatives like Treasury Bills comes only from taking stock market risk.  If you have zero exposure to market risk, you should expect the same return as T-Bills.  To generate performance above that, some market risk exposure is required.

Beta is a measure of exposure to market risk.  MN funds, then, target a beta of zero (i.e. no market risk) while shooting for annualized returns of T-Bills plus, for example, 5 percentage points.  To the extent they can achieve this target, they’ve done their job and, in this case, will enhance a portfolio’s risk-return profile.  In poor markets, like 2008 and 2002, a market neutral fund should be flat or generate modestly positive returns.  In soaring markets, market neutral funds should post respectable returns that lag sharply recovering stock markets.

So, the first difficulty in finding a good market-neutral manager is tied to the fact that many managers can’t successfully execute on their stated goal (of zero beta + hitting return targets).  Second, successfully choosing such a fund is fraught with difficulty thanks to opaque structures, secrecy of managers and the wide gap between returns of good and bad managers.  One of the funds mentioned in the above article, Picton Mahoney Market Neutral Equity, outperformed the index in 2006 and 2007 – both strong years for Canadian stocks.  So, some of its strong overall performance likely came from being net long, not from being neutral.  Clearly Picton Mahoney made the right call but this is not strictly a market neutral fund but more of an actively managed hedge fund.

None of this debunks the notion that market neutral funds – or hedge funds in general – have potential portfolio benefits.  But venturing down this path involves challenges and limitations of putting this alluring theory to work in real time.