Market-neutral funds, for example, aim to hedge out market risk and find other ways to generate a return, such as income from options, fixed income, or other securities. Calamos Market Neutral Income Fund A (ticker: CVSIX) is a prime example.
It has produced flat returns this year. But that counts as a victory in a market where the S&P 500 has tumbled more than 10% from recent highs and is now down nearly 8% for the year—almost entirely in the past week as fears of coronavirus have swept global equities.
The fund holds more than $9 billion in assets. About half the portfolio sits in convertible securities. These are a hybrid of equity and fixed-income instruments whose prices are pegged to the underlying stock and credit of the issuer.
Falling rates lift the value of the bond component of a convertible. The hybrid instruments are also sensitive to the stock price of the issuer, but the fund hedges that exposure by short-selling shares of the company, essentially isolating the yield (or coupon) from the bond.
When the market falls, the short equity positions increase in value. The bond portion of the convertible, meanwhile, can gain value if yields fall and investors seek safety in bonds.
That is precisely the dynamic in the market these days. Stocks are falling and bond prices are rising, pushing yields to near-record lows.
Morningstar analyst Erol Alitovski says the strategy should do well in declining markets with rising volatility. “When there’s more volatility in the underlying stock, the strategy can produce more profit for the position,” he said in an interview.
The remainder of the fund sits in a hedged equity strategy, which involves trading call and put options against the S&P 500. The fund sells calls, which generate income. And the managers buy puts, which gain value when the market declines, limiting the fund’s exposure to heavy market selloffs.
While the strategy helps limit losses in a falling market, it puts a limit on the fund’s gains in a rising market. The fund gained 6.4% last year, while the S&P 500 returned more than 31%. And its 10-year annualized total return of 4% isn’t in the ballpark of the 13.1% return for the SPDR S&P 500 exchange-traded fund (SPY). The fund has an annualized yield of 0.30%, based on the 30 days ended Jan. 31. Its expense ratio is 1.1%.
Another fund worth considering is Abbey Capital Futures Strategy A (ABYAX). The fund uses a managed futures strategy, designed to profit from medium- and long-term price trends in asset classes such as equities, fixed income, and commodities, according to a report by Alitovski. The fund also tries to take advantage of short-term trends in areas like currencies and global macroeconomic forecasts. It has a trailing 12-month-yield of 5.75% and an expense ratio of 2%.
“Trend-following strategies are prone to challenging performance when markets undergo sharp reversals,” Alitovski writes, “so pairing alternative strategies that have a different performance pattern should help smooth out the fund’s returns.”
The strategy appears to be paying off in this market, however. The fund is up 1.9% this year and has returned 11.6% over the past 12 months. But longer-term, the fund has racked up losses: Its total five-year annualized return is -0.74%.
Driehaus Event Driven (DEVDX) is another fund with a low correlation to the equity market. The managers look for merger-arbitrage opportunities, special situations such as spinoffs, and so-called catalyst-driven stocks and bonds (such as fixed income securities that may benefit from a credit ratings change). They also use hedging strategies to reduce exposure to market volatility and rates.
The fund has a correlation of 0.65 to the S&P 500, meaning that it’s only about two thirds as volatile as the market. It has returned 5.5% this year and has a trailing 12-month yield of 3.25%. Its expense ratio is 1.59%.
The fund did well in 2019, gaining 19.5%. But its five-year annualized return was 4.9%, about half the 10.2% annualized gain for the SPDR S&P 500 ETF.
None of the funds are inexpensive. Their expense ratios are all high compared to index funds and traditional active stock and bond funds.
High fees erode your returns long-term. The reason to own these funds is for near-term protection against a selloff in the equity market, but don’t expect much payoff if the bull market resumes or by holding them for many years.
Write to Daren Fonda at email@example.com
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