Market neutral funds: diversifier or market proxy?

12 Mar 2019

The Australian equities market has been nothing if not robust since 2012, turning in six positive calendar years of performance to 2017. As a result, the negative performance of calendar 2018 served as a reminder that alternative sources of returns are required to ensure balance within an investor's portfolio.

However, alternatives in the form of Australian market neutral funds largely turned in a relatively disappointing performance over 2018, with Zenith’s rated funds returning an average of -3.2% (after fees), which was roughly in line with broader Australian equities.

Given the performance outcomes, investors could be justified in questioning the diversification benefits of market neutral strategies. Drawing from Zenith’s 2019 Market Neutral Sector Review, we investigate some of the key factors behind the recent performance of Zenith’s rated Australian market neutral funds.

What contributed to the negative performance in 2018?

Despite broader market volatility, there was low dispersion (variation of returns) amongst individual stocks. Market neutral strategies take long positions in stocks they believe are likely to rise and short sell stocks that they expect to fall. Accordingly, greater levels of stock dispersion correspond to a healthier market environment for active managers to outperform. Stock dispersion levels have been at historical lows over the 2018 calendar year.

In addition to the reduced dispersion, Australian market neutral funds typically maintain a net long bias towards smaller companies, holding a greater portion of smaller companies in the long portfolio relative to the short portfolio.

Given the difficulties of short selling smaller companies, this is not unexpected. Limited availability of stock borrow increases the costs of short selling smaller companies. This combined with limited liquidity and heightened levels of volatility makes smaller companies a challenging segment of the market for managers to enact short positions.

With the structural size bias in portfolios, dislocations in performance between larger and smaller companies can have a material impact on the returns of market neutral funds. The 5.6% relative underperformance of Australian smaller companies versus larger companies of over 12-month period ending 31 December 2018 underpinned the strong headwind that market neutral managers faced in 2018.

Where were the expected diversification benefits from our market neutral funds in the equity market drawdown in the fourth quarter 2018?

While alternative investments such as market neutral strategies are expected to provide diversification benefits to an investor’s portfolio, market neutral strategies are expected to have no correlation to equity markets, not negative correlations. Zenith believes this is a very important distinction and one that is often forgotten.

As shown in the chart below, market neutral funds can exhibit slightly positive or negative correlations to Australian equities at different times in the cycle, even if the longer-term average is approximately zero.

Chart Source: Fund Managers, Reuters

Importantly, Zenith notes that Australian market neutral funds protected capital relative to the Australian equity market in the fourth quarter of 2018, with the average fund falling 5.8% versus 8.4% for the broader market.

Given the relatively disappointing recent outcomes, should investors maintain an exposure to market neutral funds?

Zenith believes it is important to remember that market neutral funds are expected to have a low correlation, not negative correlation, with equities. As such, there may be short periods where market neutral strategies exhibit similar directional movements with equities. However, in these relatively isolated instances where both experience negative returns, we expect market neutral strategies to protect capital, as was the case in 2018.

Ultimately, we maintain belief that market neutral strategies are an important diversifier in an investor’s portfolio.

By Quan Nguyen, Head of Equities