David Masters looks at US mutual fund trends

As the credibility of index-tracking funds continues to increase, so active management re-invents itself for mainstream consumption. This often means identifying how current trends in the institutional sector can be redefined for retail investors.

The recent law change to allow US mutual funds to adopt the market neutral strategy is just the latest example. The irony is, of course, that the market neutral strategy (go long on undervalued stock, short on overvalued) depends almost entirely for its success on the manager's skill. Having invested huge amounts in index funds in the past few years, retail and institutional investors are looking to active management techniques to provide a safe haven in volatile times.

Obviously, big index trackers are still pulling in huge sums of money. There are limited opportunities for US investors to select market neutral and other alternative investment" focused mutual funds. Nevertheless, market neutral is a logical progression. It follows on from enhanced indexed funds, bull and bear funds and, more recently, ultra bull and ultra bear funds (which seek to outperform the index and invert the index respectively, each by 200%), all of which re-packaged active management using strategies normally reserved for hedge funds and private accounts. If we look at market neutral hedge funds over the past few years, we can see they have offered reasonable if unspectacular returns (see Table 1). In terms of risk/returns, however, market neutral hedge funds have provided far superior results due to the discipline's control of risk. In the performance period monitored, the correlation coefficient between market neutral hedge funds and the S&P500 has never exceeded 0.36 and today is less than that. Institutional and mutual fund investors are searching for market neutral strategies to add to their overall portfolios.

In the US, "aggressive growth" funds have been around for some time. These funds can focus on merger arbitrage, short-term trading, short selling, distressed securities, commodities and derivatives for "non-hedging" purposes. Whilst many of these funds are only mildly aggressive, there are a significant number whose strategies make some bona fide hedge funds seem pale by comparison. Some of these aggressive strategies can benefit the investor by providing diversification because of their low correlation to core investments (such as index funds).

Whether such vehicles are "aggressive" or "neutral", they tend to be expensive. Their extreme volatility can be attractive but often the inconsistency of returns (see Table 2) can be a deterrent to more risk-averse investors. Nevertheless, the rise of the market neutral funds, a blend of sophisticated investment practice and good, old fashioned stock-picking, bodes well for active management - for the moment.

David Masters is with S&P's Micropal in Boston"