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4 Key Reasons To Consider Market Neutral Investing

Summary The Invesco Quantitative Strategies team believes one way to buffer the effects of market downturns, volatility and rising interest rates is to add market neutral equity strategies to traditional portfolios. The strategies may offer several potential benefits to investor portfolios, including diversification from traditional asset classes, ability to dampen volatility, cushion against equity market declines and boost from rising rates. We believe a market neutral equity strategy can be an excellent diversification tool that enables investors to pursue increased returns from assets that respond differently to changing markets. Low correlation, downside protection and rising rate performance among key benefits By Kenneth Masse, Client Portfolio Manager The market downturn and ensuing volatility in the third quarter of 2015 is a timely reminder about the benefits of diversifying your portfolio with investment strategies that are expected to exhibit little-to-no correlation with the broad equity and bond markets. Moreover, as the US enters the late innings of its current economic growth cycle, many professional and individual investors are expecting lower returns from equities going forward than they’ve enjoyed over the last few years. These lowered expectations are on top of concern about what will happen to investors’ bond holdings when today’s historically low interest rates eventually rise. The Invesco Quantitative Strategies team believes one potential way to buffer the effects of market downturns, volatility and rising interest rates is to add market neutral equity strategies to traditional portfolios, as they potentially offer a unique approach to generating return regardless of the general movements of the equity and bond markets. In this blog, I outline four of the top reasons to consider market neutral equity strategies: 1. They have very low levels of correlation to other asset classes One of the ways investors attempt to manage and mitigate risk is by combining strategies that differ within and across asset classes to help diversify their return pattern over time. Using this approach, investors’ wealth creation is not tied to the fortunes of just one or a few investment options. Since market neutral strategies typically seek to eliminate exposure to the broader market, these strategies have also delivered attractively low levels of correlation, not only to the equity markets, but to other broad asset classes as well. As shown in Figure 1, from January 1997 to August 2015, market neutral strategies had only a 0.18 correlation to equities and a 0.04 correlation to bonds. Market neutral also had low correlation to another popular asset class, commodities, as well as to other segments of the fixed income market, such as leveraged loans and high yield. As investors seek to diversify their holdings in order to lower overall volatility, we believe market neutral strategies should be considered as a way to achieve that goal. Sources: Invesco and StyleADVISOR. (January 1997 – August 2015) BarclayHedge Alternative Investment Database. Past performance is not a guarantee of future results. Investments cannot be made directly into an index. 2. They may offer lower levels of total volatility Another way to potentially mitigate risk across an investment lineup is to include strategies that may offer lower levels of total volatility (variation in portfolio returns). Even if these strategies were perfectly correlated with other investments, their potentially lower total volatility profile could help lower the overall average volatility of the full lineup. Market neutral strategies also may be appealing to investors from this total volatility perspective, as their volatility has tended to be less than the broader equity markets, and in some cases, similar to broad fixed income indexes (see Figure 2). Furthermore, since market neutral returns are expected to be independent of the broader equity market, a spike in market-level volatility may not necessarily mean a spike in market neutral volatility. Sources: Invesco and StyleADVISOR. (January 1997 – August 2015). BarclayHedge Alternative Investment Database. Past performance is not a guarantee of future results. Investments cannot be made directly into an index. 3. They have a history of attractive downside protection during extreme market stress Another often-cited potential benefit of market neutral is that the strategies may offer investors a way to mitigate severe losses during a sharp equity market sell-off. Because these strategies typically have beta exposure to the market that hovers around zero, a big drop (or surge) in equities should not influence the performance of the strategy. This contrasts sharply with traditional, benchmark-centric strategies, which typically have very high levels of market exposure and tend to vary similarly to the broader market. Sources: Invesco and StyleADVISOR. January 1997 – August 2015. BarclayHedge Alternative Investment Database. Past performance is not a guarantee of future results. Investments cannot be made directly into an index. 4. They can provide an opportunity for higher returns in a rising interest rate environment. We believe an increase in the federal funds rate from the US Federal Reserve is inevitable; at this point it’s simply a matter of when and by how much. For market neutral equity strategies, a rise in interest rates – specifically short-term interest rates – can potentially provide a boost to returns. This occurs when market neutral equity strategies short a stock and receive proceeds from that sale. Those proceeds typically earn a rate of return tied to the prevailing short-term interest rate, such as the fed funds rate. When that rate increases, so does the interest earned by market neutral equity strategies on their short sale proceeds Key takeaway We believe a market neutral equity strategy is a valuable complement to a traditional portfolio of stocks and bonds, as well as an excellent diversification tool that enables investors to pursue increased returns from assets that respond differently to changing market conditions. Such characteristics may be important to today’s investors given the recent market downturn, volatility and expectation of rising interest rates. Important information Beta is a measure of risk representing how a security is expected to respond to general market movements. Correlation is the degree to which two investments have historically moved in relation to each other. Volatility measures the amount of fluctuation in the price of a security or portfolio over time. The S&P 500® Index is an unmanaged index considered representative of the US stock market. The S&P/LSTA US Leveraged Loan 100 Index is representative of the performance of the largest facilities in the leveraged loan market. The S&P GSCI Index is an unmanaged world production-weighted index composed of the principal physical commodities that are the subject of active, liquid futures markets. The BofA Merrill Lynch US High Yield Index tracks the performance of US dollar-denominated, below-investment-grade corporate debt publicly issued in the US domestic market. BarclayHedge Alternative Investment Database is a computerized database that tracks and analyzes the performance of approximately 6800 hedge fund and managed futures investment programs worldwide. BarclayHedge has created and regularly updates 18 proprietary hedge fund indices and 10 managed futures indices. BarclayHedge indexes reflect performance of hedge funds, not of retail investment strategies, and are used for illustrative purposes only solely as points of reference in evaluating alternative investment strategies. Please note: BarclayHedge is not affiliated with Barclays Bank or any of its affiliated entities. Performance for funds included in the BarclayHedge indices is reported underlying fees in net of fees. About risk Commodities may subject an investor to greater volatility than traditional securities such as stocks and bonds and can fluctuate significantly based on weather, political, tax, and other regulatory and market developments. Fixed-income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating. Most senior loans are made to corporations with below investment-grade credit ratings and are subject to significant credit, valuation and liquidity risk. The value of the collateral securing a loan may not be sufficient to cover the amount owed, may be found invalid or may be used to pay other outstanding obligations of the borrower under applicable law. There is also the risk that the collateral may be difficult to liquidate, or that a majority of the collateral may be illiquid. Junk bonds involve a greater risk of default or price changes due to changes in the issuer’s credit quality. The values of junk bonds fluctuate more than those of high quality bonds and can decline significantly over short time periods. Derivatives may be more volatile and less liquid than traditional investments and are subject to market, interest rate, credit, leverage, counterparty and management risks. An investment in a derivative could lose more than the cash amount invested. Short sales may cause the fund to repurchase a security at a higher price, causing a loss. As there is no limit on how much the price of the security can increase, the fund’s exposure is unlimited. The information provided is for educational purposes only and does not constitute a recommendation of the suitability of any investment strategy for a particular investor. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals. NOT FDIC INSURED MAY LOSE VALUE NO BANK GUARANTEE All data provided by Invesco unless otherwise noted. Invesco Distributors, Inc. is the US distributor for Invesco Ltd.’s retail products and collective trust funds. Invesco Advisers, Inc. and other affiliated investment advisers mentioned provide investment advisory services and do not sell securities. Invesco Unit Investment Trusts are distributed by the sponsor, Invesco Capital Markets, Inc., and broker-dealers including Invesco Distributors, Inc. PowerShares® is a registered trademark of Invesco PowerShares Capital Management LLC (Invesco PowerShares). Each entity is an indirect, wholly owned subsidiary of Invesco Ltd. ©2015 Invesco Ltd. All rights reserved. Four key reasons to consider market neutral investing by Invesco Blog

Source Capital: Big Change Is Coming At This Closed-End Fund

SOR has a long and solid history. But the long-time portfolio manager has retired. The portfolio remake in the wake of his retirement changes everything. Source Capital (NYSE: SOR ) is one of the old timers in the closed-end fund, or CEF, world. Over the long haul it’s done pretty well, using a focused portfolio to opportunistically invest in small- and mid-cap companies with high returns on equity. But now that the manager is has retired, throw that history out. Source Capital’s advisor, FPA Group, is changing everything . Out with the old Source Capital’s now-retired manager was Eric Ende. He had been with FPA since 1984 and worked closely with the fund’s previous manager. He took over the fund in 1996 and basically kept running the fund the same way it had been run previously. But Ende has now retired. SOR data by YCharts Unlike the last manager transition, which was nearly 20 years ago, there’s no smooth hand off planned. FPA is taking an entirely new approach with the fund. That’s big news that current investors shouldn’t ignore. For starters, the fund will shift from an all-equity portfolio to a balanced portfolio that mixes stocks and bonds. Stocks will vary from 50% to 70% of assets and bonds will live in the range of 30% to 50%. This, in and of itself, isn’t a bad thing. But it is a vast change from the previous all-stock focus and shareholders need to be aware of the remake. Moreover, Source will no longer be keyed in on small- and mid-cap stocks. Over the next year or so the closed-end fund will be shifted to a globally diversified large-cap focus. Again, not a bad thing, per se, but a big change from what the fund had been doing for decades. There’s also a not-so subtle shift from what was more of a growth bias to a value approach that’s going to be part of this transition. There’s a couple of take aways here. The first is that the closed-end fund’s historical performance isn’t a useful guide anymore. That performance was built on an investment approach that no longer exists. So, for all intents and purposes, Source Capital should be looked at as a new fund. Second, the changes taking place will have a major impact on shareholders financially. For example, FPA expects 100% of the fund to turnover next year. Thus, every stock holding is set to be sold as it resets the portfolio to a new baseline. That will increase trading costs, but, more important, will lead to as much as $39 a share in distributions in 2016, according to FPA. Source Capital’s NAV was recently around $76 a share, so this is a really big event. And expect every penny to be taxable. Source is also going to initiate a stock repurchase program with the aim of reducing the closed-end fund’s discount to it net asset value. That discount is only around 10% right now, so it’s not a huge discrepancy. In fact, a 10% discount is the trigger for the buyback and about the average discount over the trailing three years. So this probably won’t be a big change. But combined with the portfolio remake and expected capital gains distributions, this has the potential to further shrink Source Capital over time. That could lead to higher expenses as there’s fewer assets over which to spread the costs of running the fund-which will now be run by a team of five managers. What should you do? If you’ve owned Source Capital for years, you need to rethink your commitment to the fund. It is no longer the same animal. Moreover, there’s no track record to go on anymore for this CEF and the next year is going to be one of material portfolio change. That, in turn, will lead to a large tax bill. If you like the idea of owning a balanced CEF, you might want to give the new approach some time to prove itself. But don’t look at the next year or so as the start of the new approach-the management team will need around a year to get the fund repositioned. You’ll need to sit through the transition and then start examining performance, perhaps using January 2017 as a “start” date for tracking the new approach. In other words, for a year or so, there’s no way to really know what you own here. If you don’t like the new approach or don’t want to sit through the portfolio makeover, then you might want to sell sooner rather than later. In the end, this is a big change and if you don’t buy in to it for any reason, you should get out. Yes, that could have significant tax implications for your portfolio, but the makeover is going to lead to a tax hit anyway.

Long/Short Equity Funds: The Best And Worst Of October

By DailyAlts Staff Long/short equity mutual funds bounced strongly in October. Not only did the category post a 2.88% gain in the aggregate, according to Morningstar – recovering from the prior month’s 1.78% losses – but the two worst-performing long/short equity funds in September were the category’s two best performers in October. (click to enlarge) Top Performers in October The three best-performing long/short equity mutual funds in October were: The Catalyst and Tealeaf funds returned +10.71% and +9.05%, respectively, outpacing the #3 fund’s +8.73% for the month. But while the Giralda fund posted gains for the first 10 months of 2015, STVIX and LEFIX were both in the red for the longer-term period. Indeed, STVIX and LEFIX were September’s worst performers. STVIX’s 10.71% gains in October don’t quite make up for its 11.12% losses in September. The fund, which debuted in 2010 and recently had just $7.8 million in assets under management (“AUM”), lost 15.13% of its value in the first 10 months of 2015, and was down a painful 18.66% for the three months ending October 31 – despite October’s big gains. Similarly, LEFIX’s 9.05% October gains weren’t enough to make up for its 10.72% September losses. Where the fund differs from STVIX is in its one-year returns through October 31: STVIX lost 18.26% for the period, while LEFIX gained 3.43%. LEFIX launched in 2013 and recently had $2.5 million in AUM. Finally, the Giralda Manager Fund, which gained 8.73% in October, rounded out the long/short equity category’s top three for the month. With around $190 million in AUM, the fund is much larger than its counterparts, and its long-term track record is much stronger: GDAMX debuted in 2011 and had three-year annualized returns of +12.59% through October 31. (click to enlarge) Worst Performers in October The three worst-performing long/short equity mutual funds in October were: The CMG Tactical Futures Strategy Fund was the month’s worst performer, falling 6.74%. The fund is younger and much smaller than the others on this list, having debuted in 2012 and with only $7 million in AUM as of a recent filing. For the year ending October 31, the fund returned a devastating -25.72%. Its three-year annualized returns through that date stood at -10.43%. Unlike the CMG fund, the Highland and Turner funds have much better longer-term returns, despite October’s poor performance. HHCAX lost 5.54% and TMSEX lost 4.99% in October, but the funds had respective three-year annualized returns of +13.59% and +11.67% for the period ending October 31. Both funds are rated “5-stars” by Morningstar, and had comparatively large AUM of $802.3 million [HHCAX] and $133.2 million [TMSEX], as of a recent filing. (click to enlarge) September’s Best and Worst: Follow-Up September’s top-performing long/short equity mutual funds included the LJM Preservation and Growth Fund (MUTF: LJMIX ), the AQR Long-Short Equity Fund (MUTF: QLEIX ), and the Longboard Long/Short Equity Fund (MUTF: LONGX ), with respective one-month gains of 5.25%, 3.98%, and 3.47%. In October, the funds returned -1.44%, +5.25%, and +2.54%, respectively. The Catalyst Hedged Insider Buying and Tealeaf Long/Short Deep Value funds were September’s worst performers at -11.12% and -10.72%, respectively. They bounced back to be October’s best performers, as detailed earlier in the article. The third member of last month’s triumvirate, the Goldman Sachs Long Short Fund (MUTF: GSLSX ) – which lost 7.45% in September – returned -3.74% in October, continuing its underperformance. Past performance does not necessarily predict future results.