Market Neutral Mutual Funds

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SVariance1
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Market Neutral Mutual Funds

Post by SVariance1 » Fri Jun 24, 2011 7:30 pm

Market neutral mutual funds and other alternative funds have taken in large sums of money over the past few years but what do investors get out of this investment, if that is what you call it. The 1,3 and 5 year returns are -0.1%, -0.27% and 0.82%. They go long and short often based on quant models and give you some wonderful diversification :) The sum of long and short should approximate zero (partially joking) but this is exactly what they have returned. These investments should be cheap, right? Financial engineers build models and tweak them occasionally. Not at all! They are expensive. What do you get for your money? If I want to diversify my equity exposure, I'll buy a bond fund.
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Post by nisiprius » Fri Jun 24, 2011 8:32 pm

I agree. The Vanguard Market Neutral Fund is one of the most baffling things I've ever seen.

Not sure where you're getting your numbers, though. Vanguard's summary page, under the "performance" tab, is showing 1.62%, -4.99%, -0.22%, 2.51%, and 2.72% for 1 year, 3, 5, 10, and since inception. 2.72%? My Series I savings bonds have done better.

If it were a sort of theoretical experiment, a tour-de-force, to see how close you can get to bond-like results out of stocks alone--"anything bonds can do, stocks can do better"--it is slightly interesting. Interesting to look at, I mean; not to invest in. But the answer is "not close at all." It combines the worst of both worlds; stock-like fluctuations (Vanguard puts it at 4 on their 1-5 risk-scale, same as Total Stock Market) and bond-like returns. Well, actually, Total Bond made 5.26% over ten years, so, actually half bond returns.

And why Vanguard thinks this is a good thing to put into their Managed Payout funds is utterly beyond me.

Since the minimum investment is $250,000 and the fund has only $140 million in assets under management, one can deduce that everyone who owns shares of this fund could fit in an auditorium. I'd love to know what they were thinking when they bought it.
SVariance1 wrote:If I want to diversify my equity exposure, I'll buy a bond fund.
Given a choice between a risk category of 4 and 2.52% 10-year return for Market Neutral, and a risk category of 2 and 5.26% 10-year returns for Total Bond Market fund, I can see why. :)
Last edited by nisiprius on Fri Jun 24, 2011 8:42 pm, edited 1 time in total.
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Post by Opponent Process » Fri Jun 24, 2011 8:42 pm

there must be some rationale for this or it wouldn't exist.

hedge funds also return nothing on average but rich people buy them to belong to an exclusive club and any given hedge fund can also perform very well over some period.
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Post by SVariance1 » Fri Jun 24, 2011 8:49 pm

nisiprius wrote:I agree. The Vanguard Market Neutral Fund is one of the most baffling things I've ever seen.

Not sure where you're getting your numbers, though. Vanguard's summary page, under the "performance" tab, is showing 1.62%, -4.99%, -0.22%, 2.51%, and 2.72% for 1 year, 3, 5, 10, and since inception. 2.72%?

My numbers are for the Market Neutral category average on Morningstar's website. I am surprised that Vanguard offers this Fund. Vanguard usually makes good choices for its shareholders, but IMO this is not one of them.

I am surprised to see that Vanguard's Fund has been around for 10 years. I did not realize any of these funds existed back then. Ah, I just looked it up on Vanguard's website. Vanguard took it over it 2007.

The performance data shown reflect performance for the Laudus Rosenberg U.S. Large/Mid Capitalization Long/Short Equity Fund’s Investor Shares. This fund was sponsored and managed by Charles Schwab Investment Management Inc., and subadvised by AXA Rosenberg Investment Management LLC. The Laudus fund was reorganized into Vanguard Market Neutral Fund on November 30, 2007.
Last edited by SVariance1 on Fri Jun 24, 2011 9:03 pm, edited 2 times in total.
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Post by wintermute » Fri Jun 24, 2011 8:53 pm

I believe the idea is a safe store of value. Bonds have inflation risk. See Permanent Portfolio and stable value funds.

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Post by SVariance1 » Fri Jun 24, 2011 8:56 pm

wintermute wrote:I believe the idea is a safe store of value. Bonds have inflation risk. See Permanent Portfolio and stable value funds.
How does this not have inflation risk? It returns nothing. Are you implying that there is a TIPS component included?
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Re: Market Neutral Mutual Funds

Post by xerty24 » Fri Jun 24, 2011 9:21 pm

SVariance1 wrote:These investments should be cheap, right? Financial engineers build models and tweak them occasionally. Not at all! They are expensive. What do you get for your money?
Of course they are expensive compared to regular funds, since you need trained quants to build models (which may or may not be any good). But they certainly cost more than an untrained monkey which is what the typical mutual fund uses (or an index fund where they do nothing all day and rebalance once/year).

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Post by nisiprius » Fri Jun 24, 2011 9:25 pm

Opponent Process wrote:there must be some rationale for this or it wouldn't exist.
The emperor must be wearing clothes.

I'm sure what advocates say that it is uncorrelated with stocks and therefore improves the performance of the portfolio as a whole.

Quite a lot of reputed diversifiers seemed to do what they were supposed to do around 2000-2004. Quite a few of them did turn in a convincingly opposing performance to stocks, and Vanguard Market Neutral is among them. I'd be really impressed if Market Neutral had gone up, or at least stayed "neutral," in 2008-2009, but it didn't. I wonder what went wrong? They didn't short enough stocks? They shorted the wrong ones?

Image

But if there were ever a demonstration that correlations are unstable...
Image

And, look at Total Bond Fund. It seems as if Total Bond Fund beats Market Neutral in every way. Double the return, much lower risk, and... looks to me as if the overall correlation is just as low, and more stable.
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Post by 555 » Fri Jun 24, 2011 11:17 pm

The purpose of the Vanguard Market Neutral Fund is to be put into the Vanguard Managed Payout Funds.

The purpose of the Vanguard Managed Payout Funds is to have the Vanguard Market Neutral Fund put into them.

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Post by wintermute » Sat Jun 25, 2011 1:10 am

SVariance1 wrote:
wintermute wrote:I believe the idea is a safe store of value. Bonds have inflation risk. See Permanent Portfolio and stable value funds.
How does this not have inflation risk? It returns nothing. Are you implying that there is a TIPS component included?
I should've said interest rate shock. I was thinking more of someone trying to avoid bond nav drops, but who doesn't like metals. It would be interesting to see how a MN fund performs in that scenario (since I know little about them).

Anyway, I'm just speculating. :D Ignore my posts and read nisiprius's. He actually does some research.

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Post by SVariance1 » Sat Jun 25, 2011 5:38 am

nisiprius wrote:
I'm sure what advocates say that it is uncorrelated with stocks and therefore improves the performance of the portfolio as a whole.
This is exactly what they say. To make matters worse, many of the companies that sold these things must have done so based on back tested data. They find historical patterns of performance and assume that they will work in the future. I have always been very skeptical about quant products. I can think of better ways to spend 2% in fees.
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Post by stratton » Sat Jun 25, 2011 4:37 pm

The Vanguard Market Neutral fund illustrates the managerial risk inherant in these type of funds. Some times it doesn't work real well.

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Post by TrustNoOne » Sun Jun 26, 2011 7:25 am

I think Vanguard's Market Neutral fund does a good job of being a bad example. The idea that by picking good stocks and going long with them, while shorting bad stocks to create an investment strategy that produces high returns with low risk makes a lot of sense. Sort of. The Market Neutral fund shows that even when professionals try to do that, they can fail- miserably. All the evidence I need to conclude I probably would fail worse.

Another advantage is that everytime I start thinking one of the Managed Payout funds is a good idea, I remember Market Neutral comes along with it.

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Post by SP-diceman » Sun Jun 26, 2011 8:52 am

May as well go all out, and make a market positive fund. :)

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Post by 555 » Sun Jun 26, 2011 3:40 pm

TrustNoOne wrote:"Another advantage is that everytime I start thinking one of the Managed Payout funds is a good idea, I remember Market Neutral comes along with it."
Don't forget that in addition to the Market Neutral Fund there is another component called "Other". :?
https://personal.vanguard.com/us/funds/ ... st=tab%3A2

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Post by xerty24 » Sun Jun 26, 2011 6:23 pm

TrustNoOne wrote:I think Vanguard's Market Neutral fund does a good job of being a bad example. The idea that by picking good stocks and going long with them, while shorting bad stocks to create an investment strategy that produces high returns with low risk makes a lot of sense. Sort of. The Market Neutral fund shows that even when professionals try to do that, they can fail- miserably.
I think the right conclusion to draw is that professionals good enough to make a market neutral fund with low risk and reasonable returns aren't going to work for their cut of only 1.8% ER. Hedge funds aspiring to make 20% pre-fees with a similar strategy at 2&20 are going to be charging 3-4x as much. Why would you work for 30% of the market rate for your salary if you were good?

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Post by SVariance1 » Sun Jun 26, 2011 6:49 pm

TrustNoOne wrote:I think Vanguard's Market Neutral fund does a good job of being a bad example. The idea that by picking good stocks and going long with them, while shorting bad stocks to create an investment strategy that produces high returns with low risk makes a lot of sense.
I am not sure how many of these fund managers are actually picking stocks long or short. I think that many of them implement these strategies with futures.
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Post by xerty24 » Sun Jun 26, 2011 7:26 pm

SVariance1 wrote:I am not sure how many of these fund managers are actually picking stocks long or short. I think that many of them implement these strategies with futures.
You're mistaken. Almost all of these strategies are pure equities, with ETFs or futures just for hedging sometimes. If you look at the Vanguard fund, they hold 97.5% stock and a little cash.

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Post by SVariance1 » Sun Jun 26, 2011 7:54 pm

xerty24 wrote:
SVariance1 wrote:I am not sure how many of these fund managers are actually picking stocks long or short. I think that many of them implement these strategies with futures.
You're mistaken. Almost all of these strategies are pure equities, with ETFs or futures just for hedging sometimes. If you look at the Vanguard fund, they hold 97.5% stock and a little cash.
You are right! I just took a look at the universe and the one I am most familiar with uses only futures, a few use primarily ETFs and the rest use primarily equities. They still suck :)
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Post by magician » Sun Jun 26, 2011 8:04 pm

xerty24 wrote:. . . to make a market neutral fund with low risk . . . .
A market neutral fund needn't be low risk. Beta = 0 tells you nothing about the volatility of the fund's returns. All it tells you is that its correlation of returns with the market is zero; its volatility of returns could be 20 times as high as the market's (or more).
Last edited by magician on Sun Jun 26, 2011 9:08 pm, edited 1 time in total.
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Post by magician » Sun Jun 26, 2011 8:07 pm

SVariance1 wrote:
TrustNoOne wrote:I think Vanguard's Market Neutral fund does a good job of being a bad example. The idea that by picking good stocks and going long with them, while shorting bad stocks to create an investment strategy that produces high returns with low risk makes a lot of sense.
I am not sure how many of these fund managers are actually picking stocks long or short. I think that many of them implement these strategies with futures.
Taking the short position of a futures (or forward) contract on an asset is fundamentally the same as selling the asset short. (Except that you get to keep any interim cash flows; e.g., coupon payments on bonds or dividends on stocks.)
Simplify the complicated side; don't complify the simplicated side.

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Post by SVariance1 » Sun Jun 26, 2011 8:13 pm

magician wrote:
SVariance1 wrote:
TrustNoOne wrote:I think Vanguard's Market Neutral fund does a good job of being a bad example. The idea that by picking good stocks and going long with them, while shorting bad stocks to create an investment strategy that produces high returns with low risk makes a lot of sense.
I am not sure how many of these fund managers are actually picking stocks long or short. I think that many of them implement these strategies with futures.
Taking the short position of a futures (or forward) contract on an asset is fundamentally the same as selling the asset short. (Except that you get to keep any interim cash flows; e.g., coupon payments on bonds or dividends on stocks.)
I am not sure if the equities are futures or not. I was referring to futures on indexes
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Post by SVariance1 » Sun Jun 26, 2011 8:15 pm

magician wrote:
xerty24 wrote:. . . to make a market neutral fund with low risk . . . .
A market neutral fund needn't be low risk. Beta = 0 tells you nothing about the volatility of the fund's returns. All it tells you is that its correlation of returns with the market is zero; it's volatility of returns could be 20 times as high as the market's (or more).
True but thus far they have had bond like volatility, at least in terms of standard deviation
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Post by magician » Sun Jun 26, 2011 9:08 pm

SVariance1 wrote:
magician wrote:
SVariance1 wrote:
TrustNoOne wrote:I think Vanguard's Market Neutral fund does a good job of being a bad example. The idea that by picking good stocks and going long with them, while shorting bad stocks to create an investment strategy that produces high returns with low risk makes a lot of sense.
I am not sure how many of these fund managers are actually picking stocks long or short. I think that many of them implement these strategies with futures.
Taking the short position of a futures (or forward) contract on an asset is fundamentally the same as selling the asset short. (Except that you get to keep any interim cash flows; e.g., coupon payments on bonds or dividends on stocks.)
I am not sure if the equities are futures or not. I was referring to futures on indexes
It works the same way: taking the short side of an index futures contract is the same as shorting the (entire) index.
Simplify the complicated side; don't complify the simplicated side.

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Post by xerty24 » Sun Jun 26, 2011 11:50 pm

magician wrote:
xerty24 wrote:. . . to make a market neutral fund with low risk . . . .
A market neutral fund needn't be low risk. Beta = 0 tells you nothing about the volatility of the fund's returns. All it tells you is that its correlation of returns with the market is zero; its volatility of returns could be 20 times as high as the market's (or more).
Sure, but no one building a market neutral fund is trying to pathalogically maximize risk just because its possible. If you have tight constraints on dollar, beta, sector, Barra and other factor exposures, your main problem is still finding alpha, not accidentally having 200% vol.

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Post by magician » Mon Jun 27, 2011 7:39 am

xerty24 wrote:
magician wrote:
xerty24 wrote:. . . to make a market neutral fund with low risk . . . .
A market neutral fund needn't be low risk. Beta = 0 tells you nothing about the volatility of the fund's returns. All it tells you is that its correlation of returns with the market is zero; its volatility of returns could be 20 times as high as the market's (or more).
Sure, but no one building a market neutral fund is trying to pathalogically maximize risk just because its possible.
Nor did I suggest that they were. I merely mention that it's possible that that's what they could achieve. Low beta ≠ low risk, a fact that even many investment professionals don't seem to realize.

Presumably they aren't trying to achieve negative returns, either, but they seem to do that fairly well. Their goals and their outcomes don't seem to have strong, positive correlation.
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Post by nisiprius » Mon Jun 27, 2011 8:17 am

TrustNoOne wrote:I think Vanguard's Market Neutral fund does a good job of being a bad example.
magician wrote:Presumably they aren't trying to achieve negative returns, either, but they seem to do that fairly well.
TrustNoOne's remark made me think maybe, to be fair, I should look at a couple of others. I went to Morningstar, typed in "market n", and picked the first three funds that seemed to have been around for at least ten years, plus Vanguard Market Neutral.

Plus one other fund. I wonder if you can tell which one it is without reading the caption? :)

How unimpressive can you get?

I mean, really. Who buys these things? Why?

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Post by SVariance1 » Mon Jun 27, 2011 9:40 am

Unimpressive indeed. Vanguard should take the high road and close their product. The biggest issue that I have is with the marketing of these products. Companies capitalized on the fears of investors during the credit crisis. They are suppose to be uncorrelated with other asset classes (equities), therefore they should hold up better during a down turn, which is true. This is why they became so popular. With that said, investors were probably expecting a free lunch, meaning downside protection and strong upside potential. How did they form these expectations without any real historical data? I think we will see lawsuits at some point.
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Post by magician » Mon Jun 27, 2011 10:03 am

SVariance1 wrote:They are suppose to be uncorrelated with other asset classes (equities), therefore they should hold up better during a down turn, which is true.
There's a big difference between correlations of returns and correlations of prices. A low (even negative) correlation of returns doesn't mean that when one goes down in price the other will won't go down (or will go up); they can go down together. Very fast.
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Post by SVariance1 » Mon Jun 27, 2011 10:19 am

magician wrote:
SVariance1 wrote:They are suppose to be uncorrelated with other asset classes (equities), therefore they should hold up better during a down turn, which is true.
There's a big difference between correlations of returns and correlations of prices. A low (even negative) correlation of returns doesn't mean that when one goes down in price the other will won't go down (or will go up); they can go down together. Very fast.
Sure these scenarios are possible but the most likely result is a return that is different from a traditional equity index, which is what you want if markets are falling sharply. Could it be worse, anything is possible
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Post by magician » Mon Jun 27, 2011 10:31 am

SVariance1 wrote:
magician wrote:
SVariance1 wrote:They are suppose to be uncorrelated with other asset classes (equities), therefore they should hold up better during a down turn, which is true.
There's a big difference between correlations of returns and correlations of prices. A low (even negative) correlation of returns doesn't mean that when one goes down in price the other will won't go down (or will go up); they can go down together. Very fast.
Sure these scenarios are possible but the most likely result is a return that is different from a traditional equity index, which is what you want if markets are falling sharply. Could it be worse, anything is possible
I agree that when markets are falling you want a return that is different from that of a traditional equity index. What I'm saying is that having a low correlation of returns or a low beta (the objective of a "market neutral" portfolio) doesn't tell you anything about whether your returns will be positive when the index' returns are negative.
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Post by SVariance1 » Mon Jun 27, 2011 10:42 am

magician wrote:
SVariance1 wrote:
magician wrote:
SVariance1 wrote:They are suppose to be uncorrelated with other asset classes (equities), therefore they should hold up better during a down turn, which is true.
There's a big difference between correlations of returns and correlations of prices. A low (even negative) correlation of returns doesn't mean that when one goes down in price the other will won't go down (or will go up); they can go down together. Very fast.
Sure these scenarios are possible but the most likely result is a return that is different from a traditional equity index, which is what you want if markets are falling sharply. Could it be worse, anything is possible
I agree that when markets are falling you want a return that is different from that of a traditional equity index. What I'm saying is that having a low correlation of returns or a low beta (the objective of a "market neutral" portfolio) doesn't tell you anything about whether your returns will be positive when the index' returns are negative.
Agreed. I am not saying that the returns will be positive on an absolute basis.
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Post by afan » Mon Jun 27, 2011 2:21 pm

I suppose it is back to faith in active management. If you really believe managers can pick stocks headed up and down, then why limit yourself to long-only or short-only? Our manager will not participate in general stock rallies or declines, but will consistently pick individual issues with unusually good or poor returns, and profit on both sides.

If I want uncorrelated returns, and low absolute returns, there are short term bond funds and money markets. Far lower fees, and no risks of the manager blowing up.

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