Do you need market-neutral ETFs in your portfolio?

The idea is to reduce exposure to stocks and bonds and allocate a larger portion to alternative assets. Those alternatives can take many forms. Some investors turn to hard assets or digital stores of value like gold or cryptocurrencies. Others look at private markets, including private equity, private credit, and real estate. 

Then there is a third category that tends to get less attention but is increasingly accessible: hedge fund-like alternative or market-neutral strategies designed to generate returns with low correlation to traditional assets. 

Since early 2019, regulatory changes in Canada have expanded access to liquid alternatives in both mutual fund and ETF format. Today, Canadian investors have a small but growing set of options. 

Using the Cboe Canada ETF screener, you can currently find six market-neutral ETFs available, with assets ranging from just a few million dollars for the Fidelity Market Neutral Alternative Fund (FMNA) to over $500 million for larger offerings like the Picton Market Neutral Equity Fund (PFMN).

The timing is helpful. Many of these funds launched shortly after the regulatory changes, which means we now have several years of performance data to look back on. That includes periods of market stress like the March 2020 COVID-19 crash and the 2022 bear market. The question to ask now is, “Have these strategies actually delivered on their promise of diversification?”

To answer that, we will look at how market-neutral ETFs work, examine the three largest options available in Canada, and review what the data says about their role alongside traditional stock and bond allocations.

What is a market-neutral strategy?

A market-neutral strategy falls under the broader category of alternative investing, meaning it goes beyond simply buying and holding stocks or bonds. Instead of relying on markets to rise over time, these strategies aim to generate returns regardless of overall market direction.

The reason this structure exists is that stock returns are driven by more than just company fundamentals. Broader forces such as interest-rate changes, economic growth, credit conditions, and overall market sentiment can move large groups of stocks in the same direction. Even a strong company can decline if the broader market is under pressure, for example.

Market-neutral strategies aim to minimize that effect. By balancing long and short positions, they attempt to offset market-wide movements and isolate more specific sources of risk and return. For example, a manager may be bullish on a particular sector, such as U.S. energy, but recognize that a broad market downturn could still pull those stocks lower. In that case, they might go long selected energy companies while shorting a broader market index to hedge out general market risk.

The objective is to offer an investment with a beta close to zero, meaning it has little sensitivity to overall market movements. If successful, the returns generated would come primarily from the relative performance of the long and short positions rather than from whether the market rises or falls.

A closer look at market-neutral ETFs

One thing to recognize with market-neutral strategies is the level of discretion involved. These are not rules-based index products. Portfolio managers are making active decisions on what to buy and what to short, often supported by proprietary quantitative models. The specifics of those models are not fully disclosed, which can make them feel like a “black box” to investors. That said, ETF providers still offer a general framework for how their strategies work.

Take PFMN, the largest Canadian market-neutral ETF. It runs 100% long equity exposure and 100% short equity exposure. The goal is to offset market movements and maintain an overall beta close to zero, meaning returns should be largely independent of the broader equity market. 

The fund provides transparency around its long and short exposures, including sector and geographic differences between the two sides of the portfolio.

Source: Picton Investments

A similar strategy can be seen in the Desjardins Alt Long/Short Equity Market Neutral (DANC), which also uses a long/short equity approach designed to neutralize market exposure. 

Source: Desjardins