The idea is to scale back exposure to stocks and bonds and invest a bigger portion in alternative investments. These alternatives can take many forms. Some investors resort to real assets or digital stores of value comparable to gold or cryptocurrencies. Others cope with private markets, including private equity, private credit and real estate.
Then there’s a 3rd category that tends to receive less attention but is increasingly accessible: hedge fund-like alternative or market-neutral strategies designed to generate returns with low correlation to traditional assets.
Since early 2019, regulatory changes in Canada have expanded access to liquid alternatives in each mutual fund and ETF formats. Today, Canadian investors have a small but growing number of options.
Using Cboe Canada’s ETF Screener, you may currently find six market neutral ETFs, with assets starting from just a number of million dollars for the Fidelity Market Neutral Alternative Fund (FMNA) to over $500 million for larger offerings just like the Picton Market Neutral Equity Fund (PFMN).
The timing is useful. Many of those funds were launched shortly after the regulatory changes, so we now have several years of performance data to look back on. These include periods of market stress comparable to the COVID-19 crash in March 2020 and the bear market in 2022. The query now becomes: “Did these strategies actually deliver on their diversification promise?”
To answer this query, let’s take a look at how market-neutral ETFs work, examine the three largest options available in Canada, and examine what the information says about their role alongside traditional stock and bond allocations.
What is a market neutral strategy?
A market-neutral strategy falls into the broader category of other investing, meaning it goes beyond simply buying and owning stocks or bonds. Rather than counting on markets to rise over time, these strategies aim to generate returns whatever the overall market direction.
The reason this structure exists is because stock returns usually are not driven solely by company fundamentals. Larger forces comparable to rate of interest changes, economic growth, credit conditions and general market sentiment can move large groups of stocks in the identical direction. Even a robust company can come under pressure if, for instance, the general market comes under pressure.
The article continues below promoting
X
Market-neutral strategies aim to reduce this effect. By balancing long and short positions, they try and smooth out market-wide movements and isolate more specific sources of risk and return. For example, a manager could also be bullish on a selected sector, comparable to the U.S. energy sector, but realize that a broader market downturn could still drag those stocks lower. In this case, they may take long positions on select energy corporations while shorting a broader market index to hedge overall market risk.
The goal is to supply an investment with a beta near zero, meaning it has little sensitivity to general market movements. If successful, the returns generated would come primarily from the relative performance of the long and short positions, moderately than whether the market rises or falls.
A better have a look at market neutral ETFs
With market-neutral strategies, the degree of discretion should be taken under consideration. These usually are not rules-based index products. Portfolio managers make lively decisions about what to purchase and what to short, often supported by proprietary quantitative models. The details of those models usually are not fully disclosed, which can lead to them appearing like a “black box” to investors. However, ETF providers still provide a general framework for the way their strategies work.
Take PFMN, Canada’s largest market-neutral ETF. It is 100% invested in stocks and 100% invested in stocks. The goal is to smooth out market movements and maintain an overall beta near zero, meaning returns needs to be largely independent of the broader stock market.
The fund provides transparency into its long and short exposures, including sector and geographic differences between the 2 sides of the portfolio.
Source: Picton Investments
An identical strategy could be seen within the Desjardins Alt Long/Short Equity Market Neutral (DANC). which also uses an extended/short equity approach to neutralize market risk.
Source: Desjardins
