During a bear market in which many stocks suffered huge declines, you'd think that an investment designed to eliminate market exposure would have done extremely well. Unfortunately, despite what should have been the perfect environment for them, many market-neutral mutual funds failed to deliver on their promises, leaving investors who had hoped to eliminate market risk with unexpected losses.

Why market-neutral?
The idea behind market-neutral funds isn't complicated. Unlike most mutual funds, in which shareholders own a portfolio of stocks, market-neutral funds use a combination of stock purchases and short selling in an attempt to cancel out the impact of movements in the overall stock market. By buying stocks that they expect to outperform the market and selling stocks short that they think will do badly, fund managers seek absolute returns that theoretically should be the same regardless of whether the overall market rises or falls.

That theory is one that many hedge funds have used successfully over the years. But many mutual funds, even at some well-known fund companies, haven't managed to translate the concept for their shareholders. Here's a sample of how some of these funds have performed during 2008 and 2009.


2008 Return

YTD 2009 Return

Vanguard Market-Neutral Inv (VMNFX)



James Market Neutral (JAMNX)



Janus Long/Short A (JALSX)



Calamos Market Neutral Income A (CVSIX)



Source: Morningstar.

Those returns may not look terrible at first, given how badly the stock market did last year. But when you remember that these funds are tasked with the goal of always generating a positive absolute return for investors, you can see how several of these funds have fallen short of their goals not just in last year's bloodbath but also during 2009's big bounce.

What went wrong?
More than anything, the strategy that market-neutral funds use truly emphasizes the stock-picking ability of the fund managers. With regular funds, managers can often hide behind the market's overall performance -- lagging by a couple percentage points may be costly to shareholders over the long haul, but it doesn't always draw a huge amount of attention from investors.

In contrast, when you have to pick both winners and losers accurately, the stakes are a lot higher. And when you're expected to deliver positive returns in good years and bad, it's a lot easier for shareholders to see when you make big mistakes.

That's exactly what funds like Vanguard's market-neutral fund have gone through over the past couple of years. It was extremely difficult to pick stocks that make good long positions last year, and many stocks haven't necessarily participated in this year's rebound. Vanguard has had several of its long picks, such as Kraft Foods (NYSE:KFT), Chevron (NYSE:CVX), and Bristol-Myers Squibb (NYSE:BMY), put in tepid performances so far in 2009.

If the short side of the portfolio had cooperated, Vanguard's subpar long positions wouldn't have jeopardized the fund's overall returns. Where the fund got truly hit, though, was on its short positions. Big short sales of Citigroup (NYSE:C) and Google (NASDAQ:GOOG) have truly backfired on the Vanguard fund, as both are up strongly from their 2009 lows.

Unfortunately, the fund has had short positions on Google, Apple, and many other strong stocks such as Freeport-McMoRan Copper & Gold (NYSE:FCX) and American Express (NYSE:AXP) throughout 2009. Although managers might complain that low-quality stocks have performed best during the rally while better-quality stocks have been unfairly punished, at the end of the day, market-neutral funds have to live with whatever irrational behavior the stock market presents to them.

Beware of panaceas
Market-neutral funds are just the latest in a string of investments promising the best of both worlds: solid returns without the risk that most stock investments have. The past two years have shown that you simply can't count on seeing those promises come true.

Amanda Kish knows that top-performing funds are tempting. But read what she has to say about why they'll cost you plenty in the end.

Fool contributor Dan Caplinger wants the market to be anything but neutral. He owns shares of Freeport-McMoRan. Google is a Motley Fool Rule Breakers recommendation. Apple is a Stock Advisor selection. American Express is an Inside Value selection. Try any of our Foolish newsletter services free for 30 days. The Fool's disclosure policy always takes a stand.