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On Neutral Ground

The recent bear market was one of the worst in history, but investors in the Calamos Market Neutral Fund, a mutual fund, hardly noticed. With annual total returns averaging a solid, if unspectacular, 8.4 percent from 2000 through 2002, the bear market was business as usual for them and for many other market-neutral fund investors. Indeed, removing the excitement both good and bad from market fluctuations

The recent bear market was one of the worst in history, but investors in the Calamos Market Neutral Fund, a mutual fund, hardly noticed. With annual total returns averaging a solid, if unspectacular, 8.4 percent from 2000 through 2002, the bear market was business as usual for them and for many other market-neutral fund investors. Indeed, removing the excitement — both good and bad — from market fluctuations is what market-neutral investing is all about. As the name implies, market-neutral hedge funds (and mutual funds) aim to minimize market risk and to provide consistent returns in both bull and bear markets.

“Ideally the portfolio should be completely decoupled from what happens with the overall market,” explains John Hanahan, a wealth manager and president of Yukon Capital Management in Overland Park, Kan. It's an approach many conservative investors find appealing.

Good Times in the Bad Times

Interest in market-neutral strategies exploded during the bear market, and the funds have sustained their popularity through the market's comeback. According to data compiled by Tremont Capital Management/TASS Research, market-neutral hedge fund inflows jumped almost sevenfold from 2000 to 2003. Of the approximately $615 billion in aggregate hedge fund assets the firm tracks, more than $142 billion — over 23 percent — is currently allocated to market-neutral strategies. And while this interest may wane if the market resumes a prolonged uptrend, many investors who've grown tired of the stock market's recent roller-coaster ride have acquired an enduring appreciation for the stability of market-neutral investing.

Market-neutral funds fall into two general groups: equity long/short funds and arbitrage funds. “Market-neutral long/short funds try to negate market risk by creating an equilibrium between their long and short positions,” says Stephen Dean, director of global product strategy for Orinda, Calif.-based AXA Rosenberg Investment Management, which oversees investments for the Laudus Rosenberg long/short mutual funds. These funds typically buy undervalued stocks and sell short overvalued ones with similar risk characteristics. They make money provided their long positions outperform their short positions, regardless of overall market direction.

To be sure, finding the right long/short balance can be tricky. “Most funds try to keep an equal dollar amount invested in long and short positions, but that's often insufficient to protect against market swings,” Dean says. “Consequently, many long/short funds also try to keep their portfolio beta neutral, meaning the overall market sensitivities of the long and short positions remain equal.”

Long/short strategies place a real premium on the fund manager's skills, Dean added. “Since the fund doesn't benefit from a rising market, its returns are almost entirely dependent on how well the manager chooses stocks and implements the fund's long/short strategy.”

Shooting the Gap

In contrast, arbitrage funds seek to exploit inefficient pricing relationships between related securities. These funds employ a variety of arbitrage strategies, including merger arbitrage, convertible arbitrage and capital structure arbitrage.

Merger, or risk, arbitrage is perhaps the best-known arbitrage strategy. It involves shorting an acquiring company's stock and buying shares of the target company to take advantage of the relative price spread between the two. This spread, which reflects the risk the deal will collapse, gradually decreases until it disappears completely when the transaction closes. If the deal falls apart, though, it can lead to large losses as the companies' shares rapidly revert back to their pre-announcement prices.

“Merger arbitrage funds typically risk large losses to make incremental gains on these spreads,” explains Kevin Schweitzer of Rockview Capital, a New York City-based hedge fund specializing in market-neutral arbitrage strategies. “But since 95 percent or more of the announced deals close, the chance of taking repeated material losses is low.”

Convertible arbitrage funds take a different approach. They try to exploit relative price divergences between a company's convertible bonds and common stock. When these securities become misaligned, the fund typically buys the convertible bonds and shorts the underlying stock to achieve a market-neutral position. It then collects coupon payments on the convertible bonds while it waits for the securities to revert to a more normal price relationship.

This strategy has historically provided some of the highest returns among market-neutral funds. But things are changing, according to Jeffrey Saut, managing director and chief investment strategist for St. Petersburg, Fla.-based Raymond James & Associates. “Over the past two years, the strategy has become less profitable as volatility has dropped and increased fund competition has narrowed spreads,” Saut says. “As a result, many convertible arbitrage funds have shut their doors to new investors or closed completely.”

Capital Idea

Other market-neutral funds employ a relatively new strategy called capital structure arbitrage, which focuses on price discrepancies among a company's various securities. While companies often issue different types of debt and equity securities, the spreads between these instruments should be consistent with their risk characteristics. When these spreads become mispriced, capital structure arbitrageurs buy the undervalued security and short the overvalued one.

“Like other arbitrage strategies, capital structure arbitrage involves taking advantage of spread relationships between related securities,” says Schweitzer. “But it often provides better opportunites than other arbitrage strategies because spreads are usually wider in the fixed-income area, volatility is lower, and there's less competition from other funds.”

Performance across the entire specturm of market-neutral strategies has been strong over the last few years. For example, according to Van Hedge Fund Advisors International, hedge funds that employed a market-neutral equity long/short strategy produced a compound annual return of 15.1 percent from 1999 to 2003, the latest calendar-year figures available. And hedge funds that used market-neutral arbitrage strategies weren't far behind, posting a compound annual return of 11.8 percent. When compared to the 0.6 percent loss suffered by the S&P 500 during the same period, it's not hard to understand the growing popularity of market-neutral funds.

But implementing these complex market-neutral strategies isn't cheap. Market-neutral hedge funds typically charge a management fee of at least 1 percent of assets, plus a performance fee of up to 20 percent of fund profits. And while mutual funds can be slightly cheaper — expense ratios generally run between 1.5 percent and 3 percent — they aren't necessarily a bargain either. This is especially true once you factor in transaction costs and tax inefficiencies caused by their high turnover and large short positions, which are normally treated as short-term capital gains no matter how long they're open. In fact, a recent study commissioned by the Zero Alpha Group estimates these additional costs often exceed the published expense ratios for many high-turnover mutual funds.

Something the Swiss Know

High costs aren't the only drawback to market-neutral funds. Some funds also have problems maintaining market neutrality. “Funds can be billed as market neutral for marketing purposes even though they frequently make directional bets,” explains Hanahan. And even some strict market-neutral funds can be tempted to stray from a purely neutral stance in search of higher returns, Saut says. That's why it's important for potential investors to thoroughly understand a fund manager's investment style, portfolio selection process and track record before investing.

There can also be barriers to participating in some market-neutral funds. Several of the market-neutral mutual funds have closed to new investors, including the Calamos Market Neutral Fund. And market-neutral hedge funds, like all hedge funds, are only open to “accredited investors” — those with a net worth over $1 million or whose net income exceeds $200,000, or $300,000 for couples.

Leverage can also be an issue. “Some hedge funds use more than 10-to-1 leverage to boost returns,” cautions Saut. “And with that much leverage, when things go wrong, they can do so very quickly and very violently.” He points to now-defunct Long-Term Capital Management as an example. “They were involved in fixed-income arbitrage,” explains Saut, “and when the market unexpectedly moved against them, they were so heavily leveraged they couldn't adjust in time to avoid disaster.” In fact, at the beginning of 1998, the year the fund imploded, it had a leverage factor of roughly 30-to-1.

That's one reason Hanahan believes most investors should only allocate a small portion of their assets to market-neutral funds. “Risk averse investors shouldn't put more than 5 percent to 10 percent of their portfolio in market-neutral investments,” he says, “and most of that should be in arbitrage strategies, which tend to be less volatile than their equity long/short counterparts. For investors willing to take a bit more risk, though, a slightly higher concentration with more equity long/short exposure may make sense.”

Saut also suggests investors interested in market-neutral strategies should stick with a broad mix of mutual funds or a diversified hedge fund of funds, rather than holding concentrated market-neutral positions. “Equally weighting several market-neutral strategies in a portfolio reduces overall risk without significantly impairing returns.”

Market-neutral funds aren't perfect nor are they without risk. But they can be a good alternative for investors who've grown weary of the stock market's recent gyrations, but aren't willing to accept the paltry yields and interest rate risk of fixed-income investments.

Market Neutral Plays

The top hedge funds in each of the three market neutral categories tracked by Tremont/TASS.
Fund* Category** Estimated AUM Annualized 1-Year Return Annualized 3-Year Return Annualized 5-Year Return Open/Closed
Argent Classic Convertible Arbitrage Fund LP (Class C) Convertible Arbitrage $77,240,155 10.70% 11.78% 11.58% Open
Alexandra Global Investment Fund Ltd. Convertible Arbitrage $1,649,233,184 7.86 16.01 18.76 Closed
Highbridge Capital Corporation Convertible Arbitrage $5,114,880,572 7.46 8.75 12.89 Open
Lionheart - Aurora Fund Ltd. Optimum Class Convertible Arbitrage $280,200,000 7.39 11.03 15.08 Open
Dynamic Offshore Fund Ltd. Equity Market Neutral $46,710,232 34.31 12.36 12.22 Open
Caymus Energy Fund LP Equity Market Neutral $66,267,655 13.9 9.84 NA Open
IKOS Equity Too Fund Equity Market Neutral $77,000,000 11.62 12.48 NA Open
Balboa Fund Equity Market Neutral $82,215,000 11.01 8.5 8.85 Open
Marathon Master Fund Fixed-Income Arbitrage $845,000,000 15.37 14.63 13.21 Open
MKP Credit Offshore Ltd. Fixed-Income Arbitrage $173,900,000 15.16 12.72 13.1 Closed
New Ellington Partners LP Fixed-Income Arbitrage $154,517,520 13.78 14.71 13.83 Open
Thames River Hillside Apex Fund Class A Fixed-Income Arbitrage $414,100,000 12.52 16.3 18.56 Open
Source: HedgeWorld USA and Tremont Capital Management/TASS Research *Excludes funds which did not provide at least three years of historic performance data, funds whose assets are denominated in non-U.S. currency, and multiple funds managed by the same firm.
**Includes representative funds from the convertible arbitrage, fixed-income arbitrage, and equity market neutral categories.
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