Mutual Funds
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A safe fund for a hostile market
James Market Neutral Fund plays a balancing act, buying some stocks but selling others short as it tries to defend investors from an unfriendly investment climate.
By Timothy Middleton
With the market going exactly nowhere, mutual funds that claim they can prosper in any situation ought to be prospering. Theyre not. The average market-neutral fund, as they're called, was down about 0.9% this year as of July 30, based on the records of 18 of them culled from the Lipper database.
Many financial advisers have examined these funds and found them wanting. Most market-neutral funds and long/short funds have not been good performers, says Mark Gleason, a financial adviser with Wescap Management Group in Burbank, Calif. We looked at many, tried a few, stuck with even fewer.
But in a market where bonds are under as much pressure as stocks and havens correspondingly hard to find, market-neutral funds are getting a fresh look as a defense against an enduringly hostile investment climate.
Steve Henningsen, a financial adviser with Wealth Conservancy in Boulder, Colo., says he's using them, as well as commodities and gold funds, to hedge client portfolios. This is not just an exploration for future returns, but a move towards wealth preservation over accumulation, he says.
Miserable returns from traditional mutual funds are making the meager results of the market-neutral type seem attractive in comparison, particularly since they are often far less risky than conventional funds.
Closing the doors
Indeed, interest in the group has already led to the biggest of these funds, Merger Fund (MERFX), to close in March because its assets were ballooning to their current level of nearly $1.9 billion. (Merger Fund seeks to avoid market risk by arbitraging takeover stocks, as I explained in a column in February.)
With Merger Fund down 1.8% this year, as of Aug. 4, the more successful strategy has been long/short. These are funds that balance ownership of favored securities with shorting the least-favored type. (Short selling involves borrowing and then selling the shares in the hope that the stock price will fall, allowing the investor to replace the borrowed shares at a lower price.)
The most successful of these funds currently, James Market Neutral Fund (JAMNX), was up 5.8% at the end of July. Its success, however, belies the steep odds these funds face in delivering decent returns. Foremost among these are stratospheric expenses at long/short funds, the most numerous type, that can subtract as much as 250 basis points from net returns.
James Market Neutral is operated by James Investment Research, based in suburban Dayton, Ohio. It uses quantitative models to comb a database of about 9,000 stocks to find those with the most attractive valuations, the strongest earnings growth and the best price performance relative to their peers. The research also identifies the least attractive stocks, and this fund buys the former and shorts the latter.
James was launched in 1998, the year the Securities and Exchange Commission changed its rules to allow mutual funds to engage in significant shorting. Before, shorting was viewed as too risky for small investors, and only hedge funds targeted at so-called sophisticated investors did it.
Tolerable risk
The risks at James Market Neutral have proved quite tolerable -- price volatility about half the markets level. Shorting has also largely immunized the fund against market gyrations, reducing the funds market sensitivity, or R-squared, to 22% of the S&P 500 Index.
But shareholders have paid a steep price to earn returns that have averaged 2.9% annually since inception. One of these is that shorting backfires in a raging bull market. This fund declined 10.8% in 1999, as the tech bubble expanded.
The more enduring price is high management, trading and other costs. The funds expense ratio is 2.48%, and thats the norm at such funds. James Market Neutral fund shorts twice as many stocks as it buys, meaning it has to do three times as much research as a long-only fund. It also has to pay dividends to the owners of shares it has borrowed and sold short, which accounts for about 50 basis points, or half a percentage point, of lost performance.
But Barry James, president of James Funds and lead manager of this portfolio, says the costs are worth the benefits. Capital preservation is most important to us, James says, and the funds returns were positive throughout the bear market.
James puts his money where his mouth is: He, his family and his employees are the largest investors in the fund, which has a tiny asset base of $13 million. He uses it as a hedge in his personal portfolio and recommends clients put no more than 10% to 15% of their assets in this strategy.
Covering the bases
There are four James Funds, the other three being balanced, large-capitalization and small, and they have total assets of $100 million.
| James Market Neutral's top positions | | Security | Industry | | Long | | | Sierra Health (SIE, news, msgs) | HMO | | Vimple-communications (VIP, news, msgs) | Wireless communications | | Schnitzer Steel (SCHN, news, msgs) | Steel & iron | | Jarden (JAH, news, msgs) | Rubber & plastics | | Helen of Troy (HELE, news, msgs) | Appliances | | Short | | | Cabot Microelectronics (CCMP, news, msgs) | Specialty chemicals | | Capitol Federal (CFFN, news, msgs) | Savings & loans | | DeVry (DV, news, msgs) | Education | | Diamond Offshore (DO, news, msgs) | Oil & gas | | Emcor (EME, news, msgs) | Construction |
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Sources: James Fund, MSN Money
Because borrowed stocks are sold for cash, James Market Neutral actually controls about $20 million of investments, 60% in cash and the balance in long positions. The fund owns about 20 long positions and is short about 40.
Barry James says his firms research indicates that the stocks picked by its models, and then adjusted so the overall portfolio doesnt heavily overweight or underweight important market sectors, will deliver gross returns in the range of 8% to 14% annually. Net returns are reduced by high expenses, including trading costs. Last year, the net return was 3.2%.
Last year was a very successful one for stocks, but James insists that comparing his funds performance with traditional asset groups is misleading. Its an uncorrelating asset, he says. The fund did better than stocks or bonds in 2000, but better than stocks and worse than bonds in 2001 and 2002. In this year's first six months, it did better than both.
The parameters
James Market Neutrals standard deviation, or historical price performance, indicates that in a normal year it can do no better than deliver high single-digit returns and no worse than low single-digit losses.
Investors who experienced the roaring bull markets in both stocks and bonds in the 1980s and 1990s will find those numbers disappointing. But in the new millennium they're pretty respectable. Rival hedges such as ultrashort-term bonds (up 0.3% in the year's first half) and gold (down 19.5%) are even less appealing.
Jamess firm was founded by Barrys father, Frank, and Frank James is a name many Americans can instantly identify as the brother of Jesse, the 19th centurys most notorious train robber. Barry says: Frank and Jesse James were distant relatives. We try to make deposits, not withdrawals, though.
In the current age of international lawlessness, with al Qaeda reportedly scheming to blow up the World Bank, having a few dollars off the conventional financial rails doesnt sound like a bad idea.
At the time of publication, Timothy Middleton didnt own any securities mentioned in this article.
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