Equity-Like Returns With Bond-Like Risk? Not So Fast!

(MoneyWatch)  Market-neutral funds claim to produce equity-like returns with bond-like risks. This may sound like a great deal, but you should take a closer look at these investments before you sink your money into them.

Market-neutral funds attempt to remove market risk from portfolios by being both long and short stocks. A market-neutral fund may pick two similar stocks from the same sector, purchase the one it believes will outperform and short the other.

The strategy is to lower risk by hedging bullish stock picks with an equivalent, but diversified, number of bearish (or short) bets. There are also market-neutral funds that add leverage to the strategy to boost returns. Of course, that increases risk.

In a February 2007 interview with MarketWatch, Lipper analyst Andrew Clark touted holding market-neutral funds, saying that "If you're holding bond funds for diversification, you might want to swap out some of that money for market-neutral or long-short funds. You won't pick up any more risk. And they're non-correlated to both bonds and stocks."

You should quickly run when presented with claims of funds that increase returns while reducing risk. Consider that market-neutral funds could be burned by the double whammy of the stocks they buy falling while the stocks they shorted are rising.

While market-neutral funds have attracted attention because of the idea they can deliver returns with less risk, the question for investors is: Is there truth in the marketing pitches?

The October 2009 data from the Credit Suisse/Tremont Hedge Fund Index provides us with the returns of market-neutral funds for the past 12 months. We can then compare their return to the returns of various major asset classes.

• One-Year Treasury Note -- 1.9%
• Five-Year Treasury Note -- 4.1%
• Long-Term Government Bond (20-Year) -- 11.1%
• TIPS -- 17.2%
• S&P 500 Index -- 9.8%
• MSCI EAFE Index -- 28.4%
• MSCI Emerging Markets Index -- 64.1%

So how did the market-neutral hedge funds compare to the returns of equity and fixed income indices? They lost 37.3 percent. And managed futures -- another recent favorite of Wall Street and the financial media -- produced a loss of 1 percent. Hedge funds in total returned 10.3 percent, well below the returns of a diversified equity portfolio and below that of long-term government bonds and TIPS.

Credit Suisse also produces another index of hedge fund performance called the Credit Suisse/Tremont Blue Chip Investable Hedge Fund Index. Here, the returns were slightly better, -27.5 percent for the market-neutral funds and a gain of 2.3 percent for managed futures. However, the returns for all hedge funds in the index were just 2.8 percent, below all but one-year Treasuries.

Investors should know that funds that purport to deliver higher returns with lower risk are the equivalent of snake oil. And the long-term evidence on hedge funds in general is that once adjusted for all the biases in the data, and the incremental risks they take, they have produced returns comparable to Treasury bills. And that doesn't even consider the loss of liquidity, lack of transparency and agency risk that investors in hedge funds must deal with.

Given the historical evidence, the only conclusion I can draw is that the majority of investment in hedge funds is driven by egos -- a need to be a member of an "exclusive" club. When it comes to hedge funds, investors would be well served to follow Groucho Marx's dictum: I would never join a club that would have me as a member.

Follow the series:

• Part one: Equity-Like Returns With Bond-Like Risk? Not So Fast!
• Part two: Can You Pick Losing Stocks?
• Part three: When You Wish Upon a Morningstar