Is This the Way to Beat the Next Bear Market?

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With the stock market jumping one day and plummeting the next, it's hard for investors to keep their bearings. But if you think that choosing stocks is more important than identifying the next bull market for equities in general, then some new exchange-traded funds may give you exactly the investment vehicle you're looking for.

When staying put is good enough
As their name suggests, market-neutral investments are designed to give investors returns that aren't connected to the movements of the overall stock market. For most traditional stock funds, if the overall market goes up, your fund will, too, while a down market will typically pull your fund share price down as well.

The way most market-neutral investments work is simple. Unlike typical mutual funds that only buy stocks, market-neutral funds usually have both long and short positions in different stocks. The objective that fund managers have is to make more from their long positions than they lose in their short positions when the overall market rises, and to make bigger profits from their shorts than losses from their longs when the market drops.

Market-neutral mutual funds have been around for quite a while, with mixed success. But some new ETFs from QuantShares take a new angle on market-neutral investing by giving you a variety of strategies to use. For instance:

  • The QuantShares U.S. Market Neutral Momentum Fund buys the stocks with the highest price momentum and sells short the stocks with lowest price momentum. By contrast, the QuantShares U.S. Market Neutral Anti-Momentum Fund does the exact opposite.
  • The QuantShares U.S. Market Neutral Size Fund buys stocks with the lowest market caps in a given sector and sells short those with the biggest market caps.
  • The QuantShares U.S. Market Neutral Quality Fund uses a proprietary algorithm to determine high-quality stocks and then buys them while selling short low-quality stocks.

One interesting thing about the funds is that several of them are mirror images of each other. For instance, the Momentum Fund identifies Netflix (NAS: NFLX) and Tibco Software (NAS: TIBX) as high-momentum stocks and therefore has long positions in each, while it has sold short laggards including Cisco Systems (NAS: CSCO) and Ultra Petroleum (NYS: UPL) . Yet when you look at the Anti-Momentum Fund, you'll see exactly the same positions -- but reversed. In other words, when you take them as a pair, the ETFs are completely neutral with respect to QuantShares itself -- and will remain so until market demand dictates that one ETF create more outstanding shares than the other. The proposed Neutral Beta and Neutral Anti-Beta ETFs will presumably have the same feature.

Will they work?
All of those ideas sound great in principle. What remains to be seen, though, is whether the strategies will actually work.

Most of the market-neutral mutual funds that currently exist are actively managed. That proved catastrophic for many funds in 2008 and 2009, when several of them not only lost substantial amounts of money during 2008's bear market but also missed out on the rebound in 2009.

The challenges that market-neutral funds face are formidable. Not only do they have to identify which sectors they believe will gain or lose, they also have to pick the right stocks. For instance, the Hussman Strategic Growth Fund had a big allocation to health-care stocks including Johnson & Johnson (NYS: JNJ) and WellPoint (NYS: WLP) that backfired on the fund, as health-care reform worries and a huge number of J&J recalls led to bad returns. Hussman accurately identified technology as a promising area for long positions but put its money on the wrong horse, Microsoft (NAS: MSFT) , which lagged its peers.

The benefit of the QuantShares ETFs, however, is that they're passive investors in index-based strategies, which will remove the subjective stock-picking element. The question is whether each fund's strategy will produce positive returns. Clearly, mirror-image pairs can only have one winner, so it's really up to investors to figure out which ETF they believe has the best prospects. But with net expenses of 0.81% coming in well above what standard index-tracker ETFs charge, these ETFs are already starting at a disadvantage.

Market-neutral funds aren't the only way to make money using ETFs. The Fool has three ETFs that should benefit from an improving economy in this free special report. Take a look today and start saving on fund fees.

At the time this article was published Fool contributorDan Caplingercoasts down hills in neutral like the environmentally minded cheapskate he is. You can follow him on Twitterhere. He owns shares of Hussman Strategic Growth. The Motley Fool owns shares of Microsoft, Johnson & Johnson, Cisco, and Ultra Petroleum, as well as a bull call spread position on Cisco.Motley Fool newsletter serviceshave recommended buying shares of Microsoft, WellPoint, Ultra Petroleum, Cisco, Johnson & Johnson, Netflix, and Tibco Software; buying puts on Netflix; creating a bull call spread position on Microsoft; and creating a diagonal call position on Johnson & Johnson. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Fool'sdisclosure policyhelps you put your portfolio into overdrive.

Copyright © 1995 - 2011 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

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