Market Neutral

BY SAM WILLIAMS

[This is a pre-edited draft of market neutral investing story published by Business 2.0 in June, 2003.]

The year was 1999. Bill Clinton was in the White House, Ricky Martin was on the radio, and Kathryn McDonald was in Orinda, Calif. learning to hate the term "irrational exuberance."

"That was a pretty difficult time," recalls McDonald, then a senior analyst with AXA Rosenberg Funds.

As one of the first to offer a "market neutral" mutual fund to investors under the $1 million net worth threshold, McDonald's company couldn't have been more out of sync with the times.

In a year that saw the S&P 500 gain 13 percent, Barr Rosenberg Market Neutral Fund (BRMIX), the company's conservative, value-oriented mutual fund, fell 11.7 percent.

Times change. Today, the White House has a new occupant, U.S. equity markets are coming off a three year slump, and AXA Rosenberg Value Long/Short Equity, the company's rechristened flagship fund, is boasting a 14 percent return over the last three years. In 2002, investors pulled a collective $27 billion out of mutual funds. AXA Rosenberg, meanwhile, experienced a combined $698 million surge in new investment.

For McDonald, now her company's senior product strategist when it comes to long/short equity offerings, the last three years have brought both redemption and relief.

"We never questioned (whether) we were doing the right thing, but we did look internally," she says, recalling a rigorous audit of the company's proprietary stock pricing models conducted in 1999. "Ultimately, we decided not to change, which, frankly, can be just as difficult as making a change."

Filtering out distracting market signals is the key to "long short" investing. Based on the old speculator tactic of pairs trading, the strategy is to balance each purchase with a short sale in the hopes of canceling out the underlying exposure to market drift.

How funds pull off that balancing act varies from company to company. In the case of AXA Rosenberg, a company that puts its faith in a quantitative stock valuation model that factors up to 200 financial and economic variables, it means managing two equally-sized portfolios: a long portfolio filled with undervalued companies (home builder Centex Corp., and a short portfolio filled with overvalued companies. If the market goes up, the longs should cover the shorts. If the market goes down, the opposite cancellation occurs. The end result is a return based solely on how well the stocks outperform (or under-perform) the overall market.

"For us, long short is the purest test of our stock-picking ability," says McDonald, who puts the AXA Rosenberg Value Long Short Equity's target performance at "six percent above treasury bills."

In the case of Calamos Investments, an Illinois-based company that manages the $689 million Calamos Market Neutral Fund (CVSIX), the long short strategy means buying convertible bonds, low-interest corporate debt offerings that can be exchanged for equity, and short selling the equities those bonds represent. Because convertible bonds earn interest even when the underlying stock drops, the strategy guarantees steady returns while hedging against equity downdrafts. The fund's annual load adjusted performance over the last 10 years, taking out the 1.3 percent expense ratio, is 8.7 percent.

Boring? Sure. But in today's market boring is the new sexy. During 2001, so many investors rushed to get into Calamos Market Neutral, the company feared a loss of agility in the bond market. A November, 2001 announcement closing the fund to new investors, however, triggered a second money influx as existing investors rushed to boost their holdings. In March, 2003 the company closed the fund completely, citing a 41 surge in assets since the initial announcement.

Investors still looking to get their money into a Calamos market neutral fund can check out one of the company's deferred-load funds, Calamos Market Neutral B and Market Neutral C. Both were launched in mid-2000 and have expense rations of 2.1 percent. That's a half-point higher than the industry average -- 1.62.according to the Investment Company Institute, an industry trade group -- but par for the course in the market neutral game, where managing two portfolios increases management overhead.

That overhead is one reason so few mutual funds have chosen to ride the long short wave, even after Congress lifted restrictions on mutual fund short selling in 1997. Dan McNeela, fund analyst for Morningstar, Inc., says that out of the 450 "hybrid" funds employing a mixture of holdings -- i.e. bond and equity-- or strategies, less than two dozen have major short selling components.

"Whenever you're shorting stocks, you're responsible for paying dividends on the stock you short," McNeela says. "That goes directly to the expense ratio."

Still, as any hedge fund manager will tell you, investors will forgive fees in exchange for results. Such is the rationale behind Alpha Strategies (I), an open-end mutual fund launched by Alternative Investment Partners in 2002. The fund aims for "consistent absolute returns" via asset and strategic diversification. In other words, instead of one manager making the buy and sell decisions, AIP has divided the portfolio among four separate managers, or "sub-advisers," each pursuing an independent strategy. According to the fund prospectus those strategies can range from pairs trading and Calamos-style convertible arbitrage to riskier plays involving options, futures, and distressed securities.

With a $25,000 initial investment fee and a 3.99 percent expense ratio, the fund is essentially a hedge fund with training wheels. It's also an attempt to factor in the manager and style risk associated with a single market-neutral strategy.

"From our view, there weren't a whole lot of funds that were truly market neutral," says Lee Schultheis, AIP's co-founder and chief investment officer. "We wanted something like a hedge fund of funds."

Investors looking to add market neutral funds to their portfolio should also aim for strategic diversification, says Anthony Vargas, director of investment management at Investment Advisors, Inc., a Pittsburgh based financial services company.

"What we're looking for are vehicles that are not strongly correlated with the overall market," says Vargas. "We emphasize [market neutral] for someone who takes a more conservative stance by coupling them with more traditional assets: S&P 500 funds, small cap value, small cap growth, global value, fixed income."

McDonald agrees. "We see [BRMIX] as a really nice complement to other holdings," she says, noting the fund's historically negative correlation to equity index funds. "Basically, it's something you can add to the mix, and it'll make a portfolio look better on the basis of risk-adjusted return."