Absolute return strategies that target market neutral profiles enhance the risk-adjusted return characteristics of diversified stock and bond portfolios.

Their returns and volatility are similar to bonds, but with very low correlation.

The prospect of rising interest rates makes market neutral strategies an even more vital portfolio addition.

Absolute return strategies do not sit high up in fund performance tables when compared with the steady upward march in market indices over recent years – especially the subset of strategies that are market neutral. While downright boring by comparison, there is a role for market neutral strategies in most portfolios. And even more so in a rising rate environment.

Though absolute return is often a catch-all term for strategies that have low market correlations, this article focuses on a subset of absolute return strategies: market neutral.

Market neutral strategies hedge away major systematic risks and aim to generate modestly positive returns in all market conditions, typically by taking advantage of valuation disparities between assets in a long-short structure. Theres an index for that: theEurekahedge Equity Market Neutral Hedge Fund Index, which since January 2002 has compounded annually at 4.9% with 2.0% annualized standard deviation. It is a compilation of 86 market neutral hedge funds, equally weighted. This is not an investable index. But it provides an idea of how market neutral strategies have generally performed in a variety of market and economic conditions.

Below is a table comparing this Eurekahedge market neutral index to the S&P 500 Total Return Index (SP50, with dividends reinvested) and the Vanguard Total Bond Market Index Fund ((MUTF:VBTLX), with dividends reinvested), which is a proxy for overall fixed income performance:

The Vanguard Total Bond Market Index Fund (Bonds) has similar returns to the Eurekahedge Equity Market Neutral Hedge Fund Index (Market Neutral) over the past 16 years. One may surmise that one is a substitute for the other. However, their respective return paths are dissimilar. The correlation matrix below illustrates:

Market Neutral returns have very low (slightly negative) correlation to Bonds at -0.09. This has significant portfolio implications. Logically, Market Neutrals similar returns but low correlation versus Bonds should make it a useful addition to a market and bond portfolio for all volatility objectives. Indeed it is:

Above, the orange line depicts the efficient frontier for combinations of Bonds and Market – the classic two-asset minimum variance risk/return tradeoff. The blue line adds Market Neutral to Bonds and Market. By adding Market Neutral, there is a significant pickup in return for each unit of risk (volatility) versus the classic two-asset curve.

Whats more, optimal bond allocations are very low along the superior three asset ((blue)) curve – largely replaced by Market Neutral. This partially explains why leading endowments have very high allocations in the absolute return sphere (though not all are market neutral per se), and correspondingly, very low allocations to fixed income. For example, Harvard, Yale, and Stanford have, respectively, 14%, 25%, and 23% of their endowment balances allocated to absolute return strategies. Their fixed income allocations are comparably low, at 12%, 7.5%, and 6%, respectively.

As illustrated above, market neutral strategies possess important advantages versus bonds in a diversified portfolio.

Furthermore, market neutral strategies generally outperform bonds in rising interest rate regimes. Below, we provide a performance comparison between Bonds and Market Neutral in all declining interest rate regimes since 2002:

Bonds outperformed Market Neutral in four out of five instances of sustained interest rate decreases since 2002.

The table below shows a similar presentation, but in rising interest rate regimes:

In all sustained rising interest rate regimes since 2002, Market Neutral outperformed Bonds in three out of four instances. The average compound annual return across all four rising rate periods is meaningfully higher for Market Neutral.

Due to their consistent (albeit un-spectacular) historical returns and low volatility, market neutral strategies stand out in the absolute return sphere as a significant contributor to diversified stock and bond portfolio returns. In addition, should interest rates rise prospectively, market neutral strategies are likely to outperform bonds, providing a valuable offset to potentially flat fixed income returns.

Disclosure:I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.