Market-Neutral Funds’ Varied Performance

It has been the worst year for U.S. stocks since 1994, and investors may be tempted to look for conservative funds designed to make money whether stocks rise or fall.

But why bother? These so-called market-neutral funds haven’t, for the most part, done what they’re supposed to--average returns of 6% to 10% a year no matter the market environment.

Instead, “they’ve generally lost money in up, down and sideways markets,” said Russel Kinnel, director of fund analysis at Morningstar Inc., a mutual fund research firm in Chicago.

Legg Mason Inc. plans to close its Market Neutral Primary fund later this year because of poor performance and lack of interest from investors. The fund, which was opened in February 1999, has lost 8.6% so far this year, through Tuesday.

The most popular way to run a market-neutral fund is to try to make money wagering on shares the managers expect to rise and stocks they bet will tumble. The value of the stocks they are “long,” or betting on, is equal to the value of those they are “short,” or betting against. They generally don’t make industry bets, meaning a manager might, say, buy Ford Motor Co. (ticker symbol: F) and short General Motors Corp. (GM) to keep his exposure to the auto sector neutral.

The biggest problem is that managers have twice the opportunity to mess up, and few managers are trained to intentionally pick losers.

The funds also tend to have high fees because of trading costs associated with keeping the value of the longs and shorts equal in the portfolio.

Still, a few have done well this year, especially arbitrage funds, which endeavor to make money off of the price differences of related securities.

The Merger Fund, which has been closed to new investors since last year but does open up occasionally, has been the best-performing market-neutral fund this year, up 12.6%.

The $269-million fund managed by Westchester Capital Management in Valhalla, N.Y., bets exclusively on the stocks of merging companies. In so-called merger arbitrage, a manager buys the shares of the target company, hoping to make money on the difference between the price of the stock immediately following the announcement and the price investors are paid for their shares when the deal closes.

If the deal falls apart or is done at a lower price, the strategy can backfire.

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Mixed Results

So-called market-neutral mutual funds have had mixed success this year, based on year-to-date returns through Tuesday:

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Merger Fund: +12.6%

Calamos Market Neutral: +10.0%

Lindner Market Neutral: +8.6%

Warburg Pincus Long Short: +1.1%

Phoenix-Euclid Market Neutral: -2.8%

Legg Mason Market Neutral: -8.6%

AXA Rosenberg Market Neutral: -9.6%

S&P; 500 Index: +2.7%

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Source: Bloomberg News