© Copyright 2002 Rogers Media. The following article first appeared in the April 2002 edition of BENEFITS CANADA magazine.

When the bursting of the technology bubble gave way to the most recent bear market, pension plan sponsors discovered that traditional diversification tactics did not offset as much of the market decline as they had hoped. Surpluses have been shrinking to the point where some organizations need to contribute additional funds to their plans--at the same time as their earnings fall. It's not surprising investors are drawn to a new strategy that is relatively unaffected by the markets and the economic environment. This strategy is market-neutral investing.

Historically, market-neutral investing has been considered risky. But with strong positive returns and low levels of volatility, institutional investors are finding that certain market-neutral strategies are actually less risky than traditional equity investments.

There are shortcomings to each traditional asset class. After a speculative bubble collapses, interest rates and returns decline, while liabilities grow and pension surpluses shrink. Recoveries tend to be slugg

sh. For instance, after a mild recession in 1990 the U.S. didn't experience robust economic growth again until 1995.

The markets tend to generate flat to negative returns for several years following a collapse. From 1992 to 1994, the annualized return of the Standard & Poor's (S&P) 500 composite index was only 6.25% and bonds yielded a meagre 7%--both below most actuarial assumptions. Research shows that under these conditions an asset manager's total return can be lower than a defined benefit (DB) plan's actuarial assumptions for an extended period of time.

Both market returns and bond yields are tied to the business cycle. In a slowdown or recession, asset prices decline as interest rates drop. The result is an erosion in pension surpluses. While rising bond prices help, the total returns on these investments usually aren't enough to compensate for the surplus shortage--even in the best of environments.

MARKET SYNCHRONICITY
Stock returns and interest rate changes move in the same direction as the business cycle. Pension surpluses shrink as asset values rise and liabilities fall due to a high discount rate. Conversely, surpluses shrink during an economic slowdown as asset values fall, and liabilities increase as discount rates fall. So while stocks and bonds offer diversification from a return standpoint, they can both negatively impact surpluses.

To mitigate this effect pension funds turn to international markets, hoping for a lower correlation with the local economy. But during market declines, the correlation among international equity markets usually rises. Even in flat markets, the world's equity markets often perform in synchronization.

Fixed-income returns are not enough to protect surpluses from declining equity markets either. As well, the selection of a new manager won't help if equities are generating lower total returns. Good managers can produce excellent relative returns, but their total returns will still be low. And in calculating surpluses, total returns are what count.

No wonder plan sponsors are questioning whether strategic asset allocation still works. DB plan sponsors, in particular, are concerned that the total returns generated by equity and fixed-income managers could be lower than their actuarial assumptions.

Independent performers
The Hedge Fund Research Institute (HFRI) Market Neutral index's one-year return has only a 6.4% correlation with the previous year's economic growth and the trend line is flat. This is because market-neutral funds are not tied to the markets or the economy.

Market-neutral and economic growth--January 1990 to October 2001

Source: U.S. Federal Reserve, HFRI.

Market-neutral investments may not deliver high total returns at all times, but those designed to function independently of the markets can offer an additional--even substantial--source of return. A well-crafted strategy is more likely to outperform conventional long-only investments, especially in a sluggish economy. Market-neutral tactics can offer a total return pick-up at low risk, even during the worst economic environments.

To represent market neutral as an asset class, we have selected the Hedge Fund Research Institute (HFRI) Market Neutral (MN) index. It is an asset-value weighted index of market-neutral managers launched in January 1990. The index's one-year return has a 6.4% correlation with the subsequent year's economic growth. Unlike the S&P 500, there is no trend relationship. This is because market-neutral funds are not correlated with the markets and the economy.

Market-neutral strategies have many forms. The first strategies were closely tied to value investing--going long on an undervalued asset and short on an overvalued one in a similar sector. More recently, managers using these strategies have invested in the spread between broad market categories or parts of the yield curve. In general, all market-neutral strategies turn relative return into total return by investing in the spread between investments, using long/short techniques to hedge out market exposure.

Because they are not correlated with the U.S. equity markets and economic cycle, market-neutral strategies do not rely on economic growth for success. This is how they offer a less risky way of enhancing returns, especially in uncertain times.

HOW MARKET NEUTRAL WORKS
To illustrate how market-neutral investing works, let's look at two companies in the same industry with highly correlated stock. Suppose your market-neutral manager felt that Ford Motor Co. was overvalued and General Motors (GM) Co. Ltd. was undervalued. He or she might go long on GM and short on the same amount of Ford. If GM outperformed Ford by 2%, the manager would collect the 2% spread as a total return. Whether the market goes up or down, the spread is what counts. Of course, this limits the amount of assets your market-neutral manager can manage using stocks as an investment vehicle. As a result, short-selling becomes part of a less risky strategy.

Market-neutral strategies using exchange-traded futures or options have recently been developed to take advantage of the spread between large asset classes. Futures are not subject to the limitations that come with short-selling stocks. Risk can also be fine-tuned by taking a small bet, or, if the investor is so inclined, a large bet using leverage. Either way, futures are more liquid. They have lower trading costs and allow investors to fine-tune risk. This gives institutional investors a customized market-neutral product.

Market-neutral returns are attractive, particularly when adjusted for risk. The HFRI's MN index shows market-neutral managers have long-term returns comparable to the stock market, with risk levels lower than the bond market. This low level of volatility is achieved even though managers are engaging in short-selling, which is generally considered a high-risk strategy. Because they are capturing the spread in returns of similar stocks, the risk level is actually quite low.

Market-neutral strategies are more appropriate for institutional investors than other alternative investments impacted by markets or the economy. Equity long/short strategies, for example, can have up to a 30% net long or short exposure to the market. They include an element of market timing, and can even be considered low beta/high alpha equity strategies. Likewise, global-macro funds bet on the direction of a wide variety of investment vehicles. Net exposure to the markets or the economy is not necessarily neutralized.

There is an additional risk with market-neutral strategies that a pension fund does not assume with regular stocks and bonds. If held to maturity, bonds offer a known rate of return. Stocks should grow with the economy and offer a risk premium. But market-neutral strategies do not have an economic link, so growth in assets depends on the skill of the manager.

But as we have learned from Japan over the last 12 years, economic and stock market growth are not a sure thing, even in a developed market. As long as market-neutral managers can turn relative return into total return, market-neutral strategies will offer diversification that protects pension fund surpluses and reduces volatility. BC

The Romanow Commission has released its final report on the future of healthcare in Canada.

For Commissioner Romanow's recommendations, click here.

Click here for Senator Michael Kirby's report, "The Health of Canadians – The Federal Role: Recommendations for Reform."