Little is absolute about absolute return funds

Date: Friday, February 13, 2009
Author: Mark Jewell, Associated Press

When does "absolute" imply something that in reality is far less than certain?

When it comes to absolute return funds. That's the label mutual fund companies have put on hedge fund-style products that they've been rolling out with increasing frequency the past three years. The funds seek to smooth out the bumpy, downward ride the markets have taken lately.

The problem is, the market's slide has exposed absolute return funds' big weakness: You can still lose money, even if you manage to fare better than most investors in a downturn. Absolute return funds lost an average 11.7 percent over the 12-month period ended Wednesday, according to Morningstar Inc.

Their 3-year record isn't much better: an average loss of nearly 5 percent per year. The funds are so new that there's no 5-year data.

The losses may be a shock if you think the funds all but guarantee a positive return.

"All these funds have clauses in the prospectus that say something like, 'We'll use our best efforts to achieve this absolute return,'" said Adam Bold, founder of The Mutual Fund Store, an investment management company based in Overland Park, Kan. "But, I think very few retail investors ever read a prospectus. Instead, what they see are the glossy marketing materials."

Absolute return strategies vary from fund to fund, but they typically employ methods hedge fund managers and institutional investors have long used to smooth returns. Those include short-selling — or placing a bet that a stock will decline in value — and investing in bonds, futures, options, derivatives, arbitrage and leverage.

The "absolute" label differentiates the funds from far more common "relative return" funds that seek to outperform benchmarks like the Standard & Poor's 500 index. Absolute return funds seek modest gains regardless of how broader markets perform.

Despite their recent losses, the funds' performance still looks decent compared with funds investing mainly in stocks. After all, the Standard & Poor's 500 index lost nearly 39 percent last year.

The absolute return funds are part of a broader category of "market neutral" funds that give average investors access to hedge fund strategies. Such funds gathered $5.5 billion in new investor money last year, but still account for less than 1 percent of assets in all funds available to individual investors, said Rob Ivanoff, an analyst with Financial Research Corp.

Putnam Investments has long used absolute return strategies on behalf of institutional clients, and last month launched four absolute return funds for individual investors. The funds seek annualized returns from 1 percent to 7 percent greater than those of Treasury bills, a gauge of inflation. T-bills have generally been yielding about half a percentage point the past couple months.

Returns are assessed over three years, so if a fund falls short of its target one year, it can still meet it if it improves in the other two years.

Investor fees fall and fund managers receive less if a fund fails to hit its target; the opposite is true if the fund exceeds the target.

"It puts us on the same side of the table as the client," said Bob Reynolds, Putnam's chief executive and president.

Avi Nachmany, research director of fund industry consultant Strategic Insight, expects absolute return funds to continue drawing investors nervous about volatility. And although the funds didn't perform well during last year's sharp market decline, he says the products still show promise to even out returns over the long haul.

"I think it would be a mistake to project from an event that happens once every 50 years or so, and use that as a rule to base expectations going forward," Nachmany said.

Critics like Bold, of The Mutual Fund Store, argue the funds need to establish a long-term track record before investors should consider them. And with investors so nervous these days, Bold says companies rolling out absolute return funds now are grasping at a strategy to capitalize on fear.

"These funds are being created not by the investment strategy departments of these fund companies, but by the marketing departments," Bold said. "I think it's a gimmick. Over time, I don't know how they can possibly deliver on what people think they're being promised."

Morningstar fund analyst Laura Lutton worries that many absolute return funds give their managers too much leeway to hit their target returns using a wide range of strategies.

"The manager can buy pretty much anything they want to achieve that objective," Lutton said. "And I am just concerned that the longer the leash, the more likely it is that things are going to go wrong."

Questions? E-mail the AP at investorinsight(at)ap.org.