Both Fidelity and Vanguard have mutual funds that are market neutral. From the Vanguard web site,
How could anyone benefit from such a fund? If I want to neutralize, why not put cash under the mattress? What’s more, these funds have very hefty expenses: at least 8 times the expense ratio of their other funds. Most Vanguard funds have a minimum of $3k or $10k. This fund requires a minimum deposit of $250k.
They still make returns, but they do it without correlation to the market. In finance terms, they’re very low (like 0) Beta.
So, just broadly speaking, the goal of a market neutral portfolio might be:
when the stock market goes soaring, we make 2%
when the stock market tanks, we make 2%
when the stock market goes sideways, we make 2%
eta: the fees are very high because that type of a portfolio requires constant attention and rebalancing, it’s what would be called a very ‘active’ fund.
Why not just invest in bonds?
Because the market values of bonds have their ups and downs, too, and are usually *anti-*correlated with the stock market.
The object is to limit movement, not to eliminate it. If the market has an overall upward trend over a long period, the fund will presumably reflect that. Cash under your mattress will almost always fall in value due to inflation.
Presumably, market neutral investments tend to choose companies that pay dividends. In which case, you’d have something pretty safe that still gives you money if things turn out well for the companies involved.
From the sound of it, the objective is not even to limit movement, but also not to reflect the long upward trend of the market.
This looks like a strategy for people who want to be exposed to a specific sector (because they want to bet on it), but not to the overall market. They achieve this by going long on their favoured sector, but also shorting the broad market. They make money if the market goes up, but their sector goes up more, or if the market goes down but their sector goes down less. They loose money if their sector performs worse than the overall market, whether the market is up or down overall.
If the only trend is an overall market rise, nothing should happen because your long portfolio wins, but your short portfolio loses in equal measure. Similar if the market goes down overall without concentration in any sector.
I invest in one, but the minimum isn’t that high. I have 6 months worth of my current income value just sitting in there for a rainy day - say I lose my job or something like that. It beats a bank with a bit of a return, but the purpose of the money I have invested there is not to make money. Plus it has check writing so it’s liquid, immediately available whenever I need it.
Would it be an inflation play? Putting in a location that doesn’t really carry a lot of risk but should adjust with significant inflation, unlike money in a savings account?
I’d use a floating rate bond fund for that sort of inflation hedge.
Broadly speaking there are two components involved in stock investing. One is market timing – when should I be in stocks and when should I be in bonds or cash. The second is selectivity – which stocks are going to outperform other stocks.
If you believe you have skill in the first, you should move your money between a diversified index portfolio and bonds (or shorting the market with an ETF designed to mimic the market in reverse). If you believe you have skill in the other, you want to tilt you stock portfolio to favor the ones you think will outperform.
If you think you can only do the latter and are not willing to bet at all on whether you think the market will outperform bonds, you’d create a market-neutral portfolio.
There are two distinctly different inflation risks. The first is simply unanticipated changes in the price level – random fluctuations in the CPI. The second is unanticipated changes in the expected rate of inflation.
For example, we might think inflation will be 2% in the coming year but it turns out to be 5%. That’s the first type. In addition, next year we might think expected inflation for the following year will have increased to 3%. That is the second type.
Interest rates are determined primarily from the second. That is, if we think inflation will be 2%, the current interest rate will be 2% to cover my inflation losses of lending money + something to cover the real uses of my money.
Standard bond prices will move as interest rates change. However, floating rate bonds protect you against changes in interest rates and therefore the second type of inflation risk. They do not protect you against the first type of inflation risk.
For that protection, you need something like TIPS (Treasury Inflation Protected Securities.) With TIPS, the face value of the bond is adjusted up (or down) based on the realized changes in the price level. Your coupon payment each six months is a fixed rate multiplied by the adjusted principal.
To be “completely” protected you’d need a floating-rate TIPS.
As I understand it, a perfectly market-neutral portfolio won’t adjust with inflation. Inflation is just a market rise – your longs will gain value, and your shorts will lose value with no net gain, just as if the market rise was due to good economic news.
Also, this strategy is not something that “doesn’t really carry a lot of risk”. It neutralizes overall market risk, but usually deliberately seeks out risk in one market sector or some set of favoured stocks. Vanguard’s one (which I think is one of the ones the OP mentions) is 4/5 on Vanguard’s own risk scale.
The problem with that strategy is that it is not very liquid. You cannot withdraw money from a bond before maturity; if you wanted to access your cash before the bond matures, the only option you’d have is to sell it on the secondary market. That way, you’re exposed to all sorts of market risk, since thr prices of bonds on the secondary market do go up and down. You’d want an investment which guarantees a certain rate of return and is still accessible at any time in case people want to withdraw their money. Any type of bond would conflict with the second of these conflicting objectives (of course, you can take a very short-term bond - but the interest rates on these are extremely low). Market-neutral funds are an attempt to strike this balance.
I guess no one believes in looking anything up in Investopediahuh?
IOW, these are actively managed funds that use a variety of investment strategies including short selling. That’s why the fees are so high. They require a lot more expertise and active trading not to mention more risky trading.
IMHO - the REAL reason these funds are being offered is for those interested in “efficient frontier” or “modern portfolio theory”. In and of itself - this type of investment is shit.
https://institutional.vanguard.com/iam/pdf/IAMMNB.pdf
However - there is such a thing as a free lunch in investing - if you believe in modern portfolio theory (which I do more or less) - but more importantly - they guy who came up with it won the Nobel Prize in economics decades ago.
Basically - you break down each investment into a risk (measured by standard deviation of return), return (measured by daily, monthly, or whatever % increase/decrease), and correlation between different asset classes.
It is easiest to understand when you think of a portfolio of 100% bonds. Why do people invest in bonds? Cause they are “safer” than stocks, but believe it or not - according to modern portfolio theory (and pretty much proven to be true in the decades since) - you are better off adding SOME stocks to your bond portfolio - not only to increase return, but DECREASE risk. Yes - that is not a typo. Don’t argue with me 
read up on the theory - it is true (granted you are only talking a few % here).
Anyway - any mix of asset classes has what is known as an efficient frontier. That is exactly why this type of investment was made. I’m sure they con people into getting it for other reasons, but the MPT people eat this shit up.
BTW - link is provided to show its usefulness in MPT investing - not to suggest it is shit. But any honest/intelligent investment advisor will not sell you this product by itself. Vanguard is a very respected company - I use them myself, but do not under any circumstances buy this product unless you know what alpha, beta, efficient frontier, and every other term mentioned in this thread means.
Even then - you’d better have some good reason to buy it.
Efficient frontier is obviously only good for the past - but you can sometimes make some educated guesses about the future.
Efficient frontier concepts go out the window when you’re talking about short selling though don’t they? IIRC the idea applies only to efficient markets and long assets. Aren’t short sellers by definition betting there are market inefficiencies? And market neutral funds, as well as the hedge funds upon which they are modeled use short selling extensively, do they not? Isn’t that in fact where the word ‘hedge’ in the term ‘hedge fund’ comes from?
Nope - ANY assets can be combined for an efficient frontier. The link I posted specifically talks about combining that product with others. Granted in some cases - a certain product might not lie “on the frontier” and therefore be given zero weight - but that isn’t the case here.
Your use of the words “efficient markets” and “market inefficiencies” makes me wonder if you might be thinking of the “efficient market hypothesis”. Both “efficient market hypothesis” and “modern portfolio theory” (which efficient frontier is a part of) come from academic research - and are both pretty cool (IMHO). They both use the word efficient, but they aren’t really the same thing.
You are right that the long/short thing is what a hedge is. Short sellers aren’t really betting on efficiencies directly, but I suspect you might be talking about when someone is buying/selling something for a slightly better deal than what the market is pricing it. Yes that is an inefficiency - but that is actually of the pricing EMH kind.
The “efficient” in efficient frontier - is simply the curve wherein a “perfect blend” of assets lies. It isn’t a point, but a curve - as you are picking the maximum return for a given level of risk - or conversely - the minimum risk for a desired level of return.
ETA: I should say any investment - not sure I’d say any asset. Hedge funds, bonds, gold (in theory - although less liquid if in physical form). You could put real estate in there as well - but the more you get away from liquid assets - the more you are dealing with issues with properly comparing taxes and expenses.
No more than long buyers are betting the same thing. If I see a stock and think it is more going to go up (by more than the risk-free rate) than not, I’m implicitly saying that it is priced lower than it should be right now. A perfectly efficient price discovery process would have determined that already, so either I’m wrong about the odds of it going up vs. going down or the market is not perfectly efficient.
You don’t seem to understand that an asset you short sell isn’t actually an “asset.” When you short sell, you borrow the asset, sell it and agree to pay it back within some not indefinite period of time. The person who retains title to the asset still owns it. That doesn’t change. So no, it is not an asset class subject to efficient market theory. You’re simply wrong about that.