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market neutral fundsLooking for an investment that can help manage risk in your portfolio? Consider market neutral funds, which aim to provide stable returns and mitigate risk in various stock market environments. But like with any investment strategy, it’s worth weighing the pros and cons before you commit. Here’s what you need to know about market neutral funds, and the potential benefits and drawbacks they bring.

What Is a Market Neutral Fund?

The goal of market neutral funds is to hedge risk with an investment mix consisting of short and long positions. In theory, taking both short and long positions minimizes risk, regardless of whether the market is trending upward or downward. In short, market neutral funds help insulate your portfolio from broad market swings.

While traditional funds — such as mutual funds and exchange-traded funds (ETFs) — strive to generate income for investors or profit from capital appreciation, the goal of market neutral funds is more singular: to stay neutral in the face of market volatility.

Pros of Market Neutral Funds

market neutral fundsThe biggest benefit of investing in market neutral funds is the ability to neutralize market movements in your portfolio. By giving equal weight to short and long positions, these funds are designed to withstand fluctuations in the market.

It works like this: The fund manager buys stocks they believe will increase in price, while selling off short stocks they expect to decline in price. This strategy gives the investor the best of both worlds by capturing returns that split the difference between each stock’s performance.

This can mean more stable returns for investors who have market neutral funds. Since returns are less correlated to how the stock market trends over time, investors can potentially reap the benefits of consistency if both long and short positions perform as expected.

Market neutral funds also offer a way to diversify, beyond the usual selection of mutual funds or other investments. They can offer a unique risk/reward profile that you may not get with other securities.

Cons of Market Neutral Funds

There are, however, several reasons to think twice about market neutral funds. For starters, it’s a more complex investing strategy than simply buying and selling stocks. To succeed at it, investors (or their fund managers) have to take the right positions — either long or short — for the right stocks at the right time.

For that reason, market neutral funds can be highly speculative. In addition, investing in these types of funds can cost you more. There’s more turnover in a market neutral fund, with the underlying assets being traded more frequently. And more frequent trading can mean higher taxable capital gains, if the securities are sold at a profit.

The fees you pay to invest in market neutral funds can also be higher compared to typical mutual funds or ETFs. That’s because they require advanced expertise on the part of the fund manager to choose the right balance of investments. While a hedge fund manager’s experience can potentially lead to higher returns, they tend to charge more for it in the form of management fees.

Finally, a market neutral fund strategy may not yield as many benefits to investors when stock prices are rising steadily over a longer period of time. When there are fewer market fluctuations, there may be fewer opportunities to capitalize on pricing changes when selling short.

What to Know About Investing in Market Neutral Funds

Market neutral funds can be purchased from an online brokerage. When choosing a fund, you’ll want to look at its risk profile compared to its past performance; this can give you an idea of the trade-offs in terms of risk and returns. (It should be noted, however, that past performance doesn’t necessarily guarantee future results, no matter the fund.)

Next, peek under the hood to see what the fund invests in — different market neutral funds can focus on different types of securities. Checking the asset mix can confirm whether a specific fund’s strategy aligns with your investment goals.

The right mix is also important for portfolio diversification. Holding multiple funds with the same underlying investments can actually increase risk if one of those investments sees a significant drop in value.

Finally, check the fees and expense ratio associated with the fund. Then go back to the risk/reward profile to determine what you stand to gain in relation to what you’ll pay. The fewer in fees you pay, the more of the fund’s returns you’ll get to keep.

The Bottom Line

market neutral fundsMarket neutral funds could be a worthy addition to your portfolio, but it’s important to keep the risk factor in perspective. Consider market neutral funds as a secondary or backup strategy to investing in traditional stocks, bonds and funds. That way, you’ll be set up to benefit from market neutral funds without over-exposing yourself to risk.

Tips for Investors

  • Risk tolerance can evolve over time, so it’s a good idea to review your portfolio at least once a year to make sure your investments are still meeting your needs. When reviewing your portfolio, check the fees you’re paying against the returns you’re earning, as well as an investment’s risk level to decide if it’s still a good fit.
  • Consider talking with a financial advisor about the pros and cons of market neutral funds in more detail. If you don’t have a financial advisor, finding one doesn’t have to be difficult. SmartAsset’s free tool matches you with financial advisors in your area in 5 minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.

Photo credit: ©iStock.com/cnythzl, ©iStock.com/cnythzl, ©iStock.com/AndreyPopov

Rebecca Lake Rebecca Lake is a retirement, investing and estate planning expert who has been writing about personal finance for a decade. Her expertise in the finance niche also extends to home buying, credit cards, banking and small business. She's worked directly with several major financial and insurance brands, including Citibank, Discover and AIG and her writing has appeared online at U.S. News and World Report, CreditCards.com and Investopedia. Rebecca is a graduate of the University of South Carolina and she also attended Charleston Southern University as a graduate student. Originally from central Virginia, she now lives on the North Carolina coast along with her two children.
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