"Absolute return" is primarily a marketing concept, one that has gained popularity since the recession and stock market crash, says Nadia Papagiannis, alternative investment strategist at Morningstar. Funds labeled "absolute return" follow a broad array of investing strategies and imply investors won't lose money and will always make money, she adds. "It preys upon peoples' fears that another 2008 is going to happen."
These funds use financial instruments—combinations of bonds, derivatives, commodities, currencies and stocks—in strategies designed to produce consistent returns unaffected by broader moves in financial markets. "Absolute return describes the goal rather than the investing strategy," says Joseph Jennings, an investment director for PNC Wealth Management in Baltimore, who uses some absolute return funds in client portfolios. That goal, he says: "Generate positive returns in any market environment and do so with fairly low volatility."
Financial advisers such as Keith Amburgey, chief investment officer at Rutherford Asset Planning, say they're investing in the funds because of worries interest rates will rise and hurt the value of bonds, which traditionally have been relied on to provide consistent steady returns. "If you're worried about interest rates—which we are—you end up turning to these to fill out your portfolio."
In theory, absolute return funds are structured to factor out such market risks as interest rate changes or falling stock prices. To do this, a fund such as the $3.4 billion Absolute Strategies Fund (ASFIX) uses 13 different strategies. The Eaton Vance Global Macro Absolute Return fund (EAGMX), the largest fund, with $7.6 billion in assets, invests in global debt, currencies, and derivatives. A similar approach is employed by the newest absolute return fund, the Legg Mason BW Absolute Return Opportunities Fund (LROAX), which was introduced on Feb. 28. Eaton Vance spokeswoman Robyn Tice notes that it's difficult to compare funds against each other, so investors "need to look under the covers and understand what fund strategies are." Eaton Vance's global macro fund became so popular that the firm closed it to new investors last October, she adds.
Because so many of these funds' returns are young, it's difficult to know if they actually work. Many aim for a positive return over three years or over a "full market cycle." For most of the funds, "you don't have enough of a track record to make a prudent decision," says David J. O'Brien, head of O'Brien Financial Planning in Midlothian, Va. The track record of older funds is mixed: Of the 10 existing absolute funds around in 2008, all but two lost value that year. For example, the Absolute Strategies fund lost 13.5 percent in a year that the Standard & Poor's 500 index dropped 38.5 percent.
Potential investors are left to read descriptions of fund strategies carefully and to try to gauge the skill of fund managers. Absolute return funds tend to borrow the approaches of hedge funds, as do other alternative mutual funds, such as those in the "market neutral" or "managed futures" categories.
Because many of the funds hedge market risk with an array of derivatives, much depends on these strategies' intricate details, often constructed by supercomputers and math and science PhDs. "There aren't too many managers you want to trust with that," says Rutherford's Amburgey. Investors need to learn as much as possible about a portfolio manager and make sure he's "smart and knowledgeable," he says.
Thus, despite their marketable name, properly evaluating absolute return funds is not something that can be done by the vast majority of investors or even their financial advisers, O'Brien says.
High Fees, High Taxes
It's important to remember that, while absolute return funds are designed to be less volatile than the markets, "they're still risky," says Robert Dowling, financial adviser at Modera Wealth Management. Because their performance can be unpredictable, it's best to make sure you're not betting on just one alternative approach, financial advisers say. Buy several funds or make sure a fund includes several different strategies, as the Absolute Strategies fund does.Absolute funds have other disadvantages: Because most trade so often, any gains tend to trigger higher capital gains rates. Fees can also be higher than usual. According to Bloomberg data, the expense ratios for absolute return funds can vary from less than 1 percent to almost 3 percent, though Morningstar's Papagiannis predicts expense ratios will decline with time.
Some advisers maintain absolute return funds aren't worth the effort it takes to evaluate them and fit them into a portfolio plan. Robert Schmansky, founder of Clear Financial Advisors, says that if investors' goal is to reduce volatility in a portfolio, they should stick with proven investments like bonds. For example, Treasuries can be bought and structured in a way that they provide a guaranteed income stream much like an annuity, he notes—a technique called "laddering," in which investors buy bonds with varying maturities that correspond to when they will need cash flow. "After the fees and costs of these [absolute return] funds," says Schmansky, "there are better options out there that have more of a track record."
Steverman is a reporter for Businessweek.com's Finance channel.
