A Fund For All Seasons

October 15, 2015 Keith Leslie CFA

In today’s challenging environment, investors are constantly looking for unique investment opportunities that allow them to participate in equity market upside yet still allow them to sleep at night knowing that they have downside protection.

With stock market pullbacks, volatile commodity prices, low yielding government bonds, and bank accounts that pay next to nothing, what can an investor do? Add in economic and political uncertainty and most investors become paralyzed. We believe that creating a portfolio that includes products designed to provide performance in both good times and bad times is certainly a good starting point. While most individuals own a combination of mutual funds, stocks, bonds and cash, there are other investment vehicles that should be used to round out and truly diversify a portfolio. These investment vehicles, known as alternative strategies, are available with Many different methodologies. Each approach is designed to provide something different to a portfolio and each has its own level of risk.

What most alternative strategies do have in common is that they are designed to diversify a portfolio. Some alternative strategies are designed to reduce your overall portfolio risk; not only through diversification but through downside protection. Unfortunately,these strategies are often not well understood. One such investment product is known as a market neutral strategy.

This type of fund is generally designed to provide equity-like performance over a full market cycle with bond-like volatility. It tends to underperform equity markets when they are very strong, match them when they are mediocre and outperform equity markets when they are down. This type of fund can also be known as an absolute return fund as it strives to provide positive returns each and every year regardless of whether the market is up or down. A market neutral strategy tends to show its worth in negative equity markets like 2011 or 2015 yet maybe not keep up to the strong equity markets of 2013 and 2014. If viewed in a portfolio context and over a full market cycle (which includes down markets), solid market neutral strategies have been able to enhance portfolio returns and reduce portfolio volatility. As an investor, you cannot ask for much more.

Why own a market neutral income fund?

  • Great diversification tool
  • A friend in down markets
  • Uncorrelated returns
  • An opportunity to conservatively get back into the equity markets without taking on much equity market risk
  • Great option in a low return environment as it pays a quarterly dividend, has upside potential and downside protection
  • Given that the 30 year total return of the S&P/TSX to August 31, 2015 is 8.2% per annum, owning a fund that can produce similar returns with less volatility and better downside protection is a smart investment decision

An equity market neutral strategy is designed to provide absolute returns whether the market is up or down. It exhibits zero correlation with the equity markets by holding equal long and short positions in the same sector so an investor is not affected by sector-wide events.

Returns are generated through superior stock picking and not based on broad movements of the market. While a market neutral strategy should not take the place of a diversified asset mix of mutual funds, stocks and bonds, it is a good idea to invest a portion of your portfolio in something that can go up, even when the markets are down.

Where does a market neutral income fund fit in a portfolio?

From our experience, there are many reasons to use market neutral strategies and every investor will look at things differently. We see it fitting in a portfolio in one of three ways:

  • As its own separate asset class somewhere between a stock and a bond
  • Replacement for a low yielding fixed income product
  • Replacement for a stock generally held for its yield


After combining our beliefs with the thoughts of many investors and advisors, we came up with the following investment guidelines for what we consider an ideal market neutral strategy. We feel that following these guidelines is the best way to satisfy what investors are looking for in today’s markets:

Market Investment Guidelines

  1. Add a yield component to the traditional market neutral strategy
    • Establish a dividend policy of 3% - 4% per annum.
  2. Strive to maintain net 0% equity market exposure at all times
    • Having a net long or net short position adds an element of sector and/ or market risk to the portfolio that is not suitable in a market neutral strategy.
  3. Rebalance the fund daily
    • To protect from broad market moves, a true market neutral fund should be rebalanced to eliminate market exposure at the end of every day.
  4. Always be fully invested (have conviction in the strategy
    • In a true market neutral strategy, the market direction is irrelevant so the fund should be at least 100% long and 100% short at all times so as to avoid cash drag.
  5. Commit to keeping the fund small to maintain maximum flexibility
    • Close the fund when it appears that growing any bigger will affect performance and the ability to be fully invested.
    • The most inefficient part of the Canadian market is small, mid & microcap stocks so closing the fund allows it to participate in all market segments. Remember that inefficiency = opportunity.
    • Staying small will also allow a fund to buy and sell stocks quickly without moving the market.
  6. Do Something with the leftover cash
    • The proceeds from the short positions essentially fund the long positions leaving the initial investment untouched. Invest the cash in an investment grade, short duration bond portfolio rather than earning nothing.
  7. Keep the number of holdings reasonable
    • Any additional holdings above 50 - 55 long and short positions provides minimal diversification benefits so limit the number of equity holdings to 100 - 110 and make sure the best long and short ideas impact the fund’s overall performance.
  8. Short stocks instead of indices in Canada
    • The Canadian short market is underdeveloped and thus very inefficient so take advantage of the opportunity to short this part of the market.
  9. Continually review the performance for market correlation
    • If the fund tends to go up when the market goes up or down when the market goes down, the fund is not neutral so continually monitor performance for correlations.

On the surface, the market neutral strategy appears to be complex and, as a result, it is perceived as high risk. In reality, the strategy is designed to mitigate risk. The easiest way to describe it is to say that the fund will go up as long as our favourite ideas (longs) provide better returns than our least favourite ideas (shorts), regardless of whether they are both up or both down. In other words, as long as the stocks we like do better than the stocks we don’t like, the fund will provide a positive return.

We followed these guidelines when we created the Norrep Market Neutral Income Fund at the end of December, 2010. It was designed to provide sleep-at-night returns and has been able to do just that by delivering positive returns every calendar year since its inception. We believe that by staying true to our methodology, we can provide equity-like returns with bond-like volatility for years to come.


About The Author

Keith LesliePortfolio Manager

Keith Leslie is a Portfolio Manager at NCM Investments. Keith leads two of the firm’s alternative investment strategies, with a focus on Canadian equities. He has over 17 years of investment management experience and is an award-winning Portfolio Manager. Prior…

Unless otherwise stated, opinions expressed in this document are those of the author and are not endorsed by the author’s employer. No guarantee, either express or implied, is made that the information in this document is accurate, complete or up-to-date. The contents of this document are for informational purposes only and are not intended to provide financial, legal, accounting or tax advice and should not be relied upon in that regard. Norrep Market Neutral Income Fund is only available for sale to accredited investors, to qualified investors pursuant to the Offering Memorandum Exemption or with a minimum investment of $150,000.
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