Then the financial crisis hit.

Many investors mistakenly believe that market-neutral funds should make money in both rising and declining markets. Although that may be the aim of market-neutral funds, the situation can be different in practice because market-neutral funds are inherently bullish bets. The strategy behind market-neutral funds is to take long positions in securities that managers expect to perform well, and short positions in securities that managers expect to perform poorly. Market-neutral funds can bet on broad markets, sectors or market niches.

Although market-neutral funds seem to be cash machines during good times, they can turn into serious losers when markets crash, as they did in 2008. When all asset classes tumble at the same time, only the short sellers win.

But QuantShares–which made its debut in the exchange-traded funds (ETF) world with the launch of six new market-neutral ETFs–takes a new approach to market-neutral investing. These ETFs focus on factors such as momentum, quality and volatility. Additionally, these funds will be driven by rules-based processes, a move that eliminates the subjective element that’s caused trouble for many market-neutral funds.

US Market Neutral Momentum Fund (NYSE: MOM) will divide its investable universe into 10 economic sectors–all of the new QuantShares funds incorporate this feature. The fund goes long on those names that have recorded the best performance over the first 12 months of the last 13-month period. The fund also shorts the stocks that have performed the worst over this same period. By allocating to each of the 10 sectors, the fund ensures that its performance will be sector neutral and that the portfolio will be equally divided between long and short positions. By purchasing shares of this fund, investors are essentially betting that current market leaders will remain market leaders.

US Market Neutral Anti-Momentum Fund (NYSE: NOMO) is basically the opposite of the Momentum Fund. It will short the highest momentum names and go long on the names with the least momentum, essentially betting that the current crop of laggards will become leaders.

US Market Neutral Quality Fund (NYSE: QLT) seeks to identify high-quality names as measured by debt to equity and return on equity. The fund will take long positions in companies with the highest return-on-equity readings and the lowest debt-to-equity measures. US Market Neutral Quality Fund will also take short positions in those companies deemed to be of the lowest fundamental quality. Owning shares of this ETF is essentially a bet that the markets will favor higher quality names.

US Market Neutral Size Fund (NYSE: SIZ) is suitable for investors who believe that small-cap stocks will outperform large-cap stocks. The fund takes long positions in the companies with the smallest market capitalization in each of the 10 economic sectors. The fund also establishes short positions in the companies that fall into the top-20th percentile in terms of market capitalization.

US Market Neutral Beta Fund (NYSE: BTAH) is a play on the performance spread between high volatility stocks and low volatility stocks. The fund takes long positions in the stocks with the highest volatilities as measured by beta, while establishing short positions in those with the lowest betas. When the market is climbing, this fund should perform well.

Finally, US Market Neutral Value Fund (NYSE: CHEP) measures a stock’s value by comparing equities on a number of metrics including earnings, book value and cash flows to price. The fund takes long positions in undervalued stocks and short positions in overvalued names. This is a fund that can be expected to lag during strong bull markets and perform well when the market is down.

It’s too early to say how well these funds will perform. With expense ratios of 0.81 percent, they’re expensive offerings and I would advise investors to steer clear of them for now. But once these funds establish a track record, they could be useful tools for hedging purposes or for direct bets on the markets.  

Portfolio Roundup

During the past week (Tuesday, Sept. 6 to Tuesday, Sept. 13) our Global ETF Profits Model Portfolio declined 1.3 percent, compared to a 0.7 percent gain for the S&P 500. Over the same period, the MSCI EAFE fell by just under 2 percent.

• Guggenheim China Real Estate (NYSE: TAO) declined 4.4 percent last week, despite signs China’s central bank will hold steady on interest rates for the time being. Key measures of Chinese inflation for August were more subdued than expected, lowering the need for tightening interest rates or raising bank reserve requirements. Last week’s decline was largely driven by concerns that a cooling Chinese economy will slow the pace of real estate transactions. We are less concerned; available transaction data indicates that real estate sales continue apace.

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