SprottWealth Insights

An Introduction to Market Neutral Funds

An Introduction to Market Neutral Funds: 
What they can mean to your portfolio

Market neutral funds try to produce zero market risk by balancing long and short positions, with the goal of making money under all market conditions. To achieve this objective, the funds typically invest in the managers' best ideas (long positions) while simultaneously establishing short positions in the managers' least favourite ideas (short positions). Short selling is a trading strategy designed to generate profit from an anticipated decline in the price of a stock.

 

Strategy Example

An example of a strategy employed by market neutral funds is pairs trading. In this strategy, the manager matches each long position with a short position in the same sector. For instance, the manager might feel that equities will outperform bonds and decides to go long Morgan Stanley, whose business is more heavily focused on equities, and short Goldman Sachs, with its heavier focus on bonds. The manager created a ‘market neutral’ position in the financial sector that is buffered regardless of which way the markets move.

The result is a portfolio that is uncorrelated to the direction of the market, with long and short portfolios offsetting each other in terms of market risk. The returns are largely generated through the share price appreciation in the long positions or ‘best ideas’, and declines in short positions or ‘least favourite ideas’.

 

Goals

Although the goal of market neutral funds is to make money in all market conditions, they tend to outperform the equity market when the market is flat or down and underperform in bull markets. Simply put, their goal is not to ‘shoot the lights out’, but to provide stable returns and true diversification in all market conditions.

 

Possible Risks

A fund that appears to be market-neutral may sometimes exhibit unexpected correlations as market conditions change, thereby not meeting its market neutral objectives. The risk of this occurring is called ‘basis risk’ and it’s the fund manager’s responsibility to actively manage the fund to address this risk.

There are a number of market neutral funds available to Canadian investors. We’d be happy to discuss with you which ones are most suitable for you and can best complement your core holdings, potentially reducing the overall risk of your portfolio.

 

You may also be interested to know that our SmartMoney Portfolios include market neutral funds (within selected portfolios) as part of an alternative investment strategies allocation. 

 

1 Sub-Advisor of Sprott Bridging Income Fund LP The Fund is generally exposed to the following risks. See the offering memorandum of the Fund for a description of these risks: speculative investments; limited operating history for the partnership; distributions and allocations; class risk; possible loss of limited liability; repayment of certain distributions; limited partners not entitled to participate in management; dependence of manager on key personnel; reliance on manager; dependence of sub-advisor on key personnel; reliance on sub-advisor; limited ability to liquidate investment; possible effect of redemptions; tax liability; charges to the partnership; potential indemnification obligations; not a public mutual fund; changes in investment strategies; valuation of the partnership’s investments; lack of independent experts representing limited partners; no involvement of unaffiliated selling agent; general economic and market conditions; unspecified investments; competitive environment; illiquidity of underlying investments; credit risk; impaired loans; no insurance; non-controlling investments; joint ventures and co-investments; litigation; fixed income securities; equity securities; possible correlation with traditional investments; idle cash; currency risk; concentration; indebtedness. Sprott Asset Management LP is the investment manager to the Sprott Funds (collectively, the “Funds”). Commissions, trailing commissions, management fees, other charges and expenses all may be associated with investment funds. Please read the offering memorandum carefully before investing. Investment funds are not guaranteed, their values change frequently and past performance may not be repeated.