Where to turn for Low Correlation and Downside Protection?

The market’s recent sharp movements remind investors that the only certainty about future market direction is uncertainty. Stocks sold off in October (2018), dipped again in December, enjoyed their strongest January (2019) in 30 years and then the worst day in 2019 on August 5th. Whipsawing markets have alternately punished and rewarded both long-only strategies that benefit from a broad rise in stocks and alternative strategies that capitalize on market declines.

When stocks experience a broad sell-off, most asset classes and investment strategies suffer in tandem. In reality though, only few investments are untethered to the stock market’s directional trends.

Market neutral funds are one of the only strategies that can stake this claim as their most unique characteristic is the ability to detach from broad market swings. Naturally this feature is most appreciated in sharp equity market downturns.

The following chart shows how market neutral strategies have held up relative to various equity indices during four of the worst market events from the last quarter century. An investor holding the market neutral fund would undoubtedly appreciate its stability amid such tumult.

Chart: Market Neutral Performance Over the Years

Source: Morningstar

While market neutral strategies deserve attention for their performance in the worst market environments, the general steadiness of returns is also notable. The chart below shows the average return of market neutral strategies in the months when the S&P 500 Index fell.

Down Months for the S&P 500 Index (119)
January 1, 1990 through December 31, 2018Chart: Down Months for the S&P 500 Index

Source: Morningstar

How are market neutral funds able to do this? Since market neutral funds take a relatively equal weighting in long and short positions, that balanced positioning offsets the fund’s exposure to the market’s directional trends. If stocks rise broadly, gains in the long positions offset losses in the short positions. More important, if the market falls steeply, gains in the short positions offset losses in the long holdings.

With broad market exposure muted, a market neutral fund’s performance comes down to the spread earned between long and short positions. Put simply: the manager is rewarded for their skill in identifying specific stocks poised to rise and fall, but not punished when all stocks sell off.

With trade tensions, uneven global growth and Fed policy uncertainty all continuing to grip markets, investors may benefit from strategies whose performance is wholly independent of broader market swings—like market neutral.

Read our recent blog post, FAQs: Where to Get Started With Alternatives >