During periods of increased market volatility and high correlation between traditional asset classes, some investors seek alternatives to traditional equity and fixed income securities. Typically, the primary goals of adding a new alternative asset to a portfolio are to increase diversification and enhance the overall risk/return profile.

There are various types of alternative mutual fund strategies available. Perhaps the most common type is the equity market-neutral strategy. This strategy strives to profit from the mispricing of individual stocks. An equity market-neutral fund can be dollar-neutral, in which there is an equal dollar amount of stocks long and short, or beta-neutral, in which the total market beta of the long positions equals that of the short positions. Some funds even attempt to be sector-neutral, or neutral with respect to exposure to the value and growth style of investing.

Contrary to a traditional long/short equity strategy, a market-neutral strategy does not hold a long bias, meaning that the long and short positions offset each other. The overall objective of market-neutral funds is to neutralize the market beta. In order to remain market-neutral, a fund needs to maintain an equal amount of long exposure and short exposure. This requires ongoing monitoring and adjustments due to potential price changes ofthe underlying investments over time.

Market-neutral funds are unique, since they strive to not rely on the direction of the market.

For example, an investor in the technology sector may take a long position in Microsoft and attempt to offset the exposure with an equal-sized short position in Intel. The investor is hoping that Microsoft will appreciate in value, while Intel will decline in value. The total return equals the sum of the returns from the offsetting long and short positions.

An investor should be aware that market-neutral funds tend to have higher fees compared to other exchange traded funds (ETFs) and mutual funds. These higher fees result from the ongoing rebalancing, and increased portfolio turnover. Market-neutral funds may also incur more transaction costs due to the portfolio’s ownership of a short position, since additional costs are associated with borrowing (shorting) securities.

In terms of taxes, market-neutral mutual funds are typically taxed similarly to other mutual funds with respect to dividends and capital gains. However, since these investments tend to trade more often, they may incur higher tax liabilities.

In the past, market-neutral strategies were commonly available only through hedge funds, which often had liquidity constraints and high fees. However, market neutral funds are now highly accessible through the mutual fund format. According to Morningstar, more than half of today’s market-neutral mutual funds weren’t established until after 2008. For this reason, it is imperative that investors perform due diligence on fund management. Identifying and utilizing experienced management teams that have a longer track record may be a more prudent strategy than investing in new teams with less experience.

Broadly speaking, market-neutral funds seek to provide absolute returns with low correlation to traditional equity and fixed-income securities. These types of strategies are unique, since they strive to not rely on the direction of the market; rather, their returns depend upon the spread earned between the portfolio’s long and short holdings.

Regardless of market conditions, investors may consider utilizing market-neutral funds to complement a traditional stock and bond portfolio, as these investments may lower overall portfolio volatility and increase diversification.

This article was originally published in the June/July 2016 issue of Worth.