When the Market's Bad, Stay Neutral

To earn extraordinary returns, stock investors have to endure some violent ups and downs in the market. If all the recent turbulence in stocks has you feeling airsick, then you're the target audience for a special type of mutual fund.

Market-neutral funds are a whole different animal from most mutual funds. Although they invest in stocks, their methods don't generally produce top returns. Instead, by taking advantage of market inefficiencies, or simply betting that some sectors will perform better than others, market-neutral funds seek stability and consistency with better performance than safe investments such as cash and government bonds can offer.

The long and the short of market neutrality
The bread and butter of market-neutral funds is arbitrage. These funds take advantage of inefficiencies across similar markets. For instance, companies such as Amazon.com (NASDAQ:AMZN) offer convertible bonds that investors can exchange for regular shares. If the bonds trade at a discount to the stock, then a market-neutral fund will make a small profit.

There are many different arbitrage methods. Arbitrageurs trade stock index futures against the stocks within the index. They may take advantage of a corporate event, such as a spinoff or breakup. They may even look for profits from proposed mergers, although that strategy isn't foolproof -- as investors in Yahoo! (NASDAQ:YHOO) and Microsoft (NASDAQ:MSFT) can attest after yesterday's final breakup.

Still other market-neutral funds don't use arbitrage at all. Instead, they look to buy stocks that they believe will outperform the market, while selling short stocks they've picked to underperform. For instance, the James Market Neutral (JAMNX) fund currently offsets long positions in McDonald's (NYSE:MCD) and IBM (NYSE:IBM) with shorts in XM Satellite Radio (NASDAQ:XMSR) and Evergreen Solar (NASDAQ:ESLR).

Show us the money
The primary attraction of market-neutral funds is the promise of good performance no matter how the overall stock market is doing. In coming up with a diversified asset allocation strategy, finding assets that perform differently from one another can be extremely useful.

However, the attraction of market-neutral funds is also its main shortcoming -- you can't expect the same long-term returns that stocks have historically given you. Because they seek to reduce risk, they're more likely to have returns somewhere between cash and stocks over time. Here are some examples:

Sources: Morningstar, Vanguard.
*Return for five years ended May 31, 2008.

As you can see, while most of these market-neutral funds have outperformed cash, they don't come close to the return of stocks. When stocks do really well, the gap is even larger. On the other hand, all of these funds have trounced the S&P over the past year.

Portfolio fit
So in these times of uncertainty, do market-neutral funds deserve a significant place in your investments? For most people, the answer is no. For one thing, market-neutral funds tend to be expensive, with costs ranging from 1.18% annually for the Calamos fund to a hefty 2.79% for the Vanguard fund.

More importantly, though, even when they achieve their stated purposes, market-neutral funds don't offer enough reward for most investors. Portfolio stability is nice, but you can afford to deal with larger ups and downs in the market if you have a long time horizon for your money.

Meanwhile, if you buy a market-neutral fund thinking to hold it only while the market's bad, you're essentially just trying to time the market. If you guess wrong, you'll miss out on much stronger returns from regular stock funds. As a result, you're probably better served sticking with a well balanced group of traditional stock funds for the bulk of your assets.

For more on investing in hot sectors, read about:

• How you can spot tomorrow's top performers today.
• Which five biotech stocks to keep an eye on.
• What the next ultimate growth stock will be.