Close your eyes and imagine the perfect equity investment. You're picturing one that lets you capture most of the stock market's upside without ever losing money, aren't you? Now open your eyes and presto! Financial services firms have designed the very investment you dreamed of. Never mind that some of these solutions have been around for years, gathering dust on the "specialty" shelf of your local brokerage or insurance firm. All have now been rebranded to emphasize their "safety" quotient. Among the most heavily promoted are market-neutral and absolute-return mutual funds as well as insurance/stock hybrids known as equity-indexed annuities (EIAs).
The funds use hedging and other strategies in an attempt to deliver positive returns whether stocks are rising or falling. Market-neutral funds have been around since the late 1990s, but the absolute-return funds are a more recent feat of financial engineering. EIAs — launched in the early '90s — offer a guaranteed minimum return of 2 or 3 percent a year, though puzzling out how their returns are calculated may require an MBA.
What They Are
As the name suggests, these funds aim to earn a positive return whether the market goes up or down. Different funds try to pull off this difficult feat in a variety of ways, but in a classic market-neutral strategy, the managers go long on (i.e., buy) stocks they think are stronger investments and sell short an equal amount of stocks they think are weaker. (A short position makes money if a stock goes down.) Thus, if the managers have chosen well, the longs should make more money in a rising market than the shorts lose. In a falling market, just the opposite ideally happens: The short positions make more money than the long positions lose. Market-neutral funds are found in Morningstar’s Long-Short category.
The underlying idea is that to avoid big swings in their fund’s value, managers don’t need to predict whether the market is going up or down. To make a reasonable steady return in excess of the Treasury-bill rate (T-bills currently yield between .11 percent and .28 percent) they just have to be able to distinguish between stronger stocks and weaker ones. Easier said than done.
1. High fees. The frequent trading and stock-picking finesse required by this technique mean you’ll pay steep hedge-fund-like management fees, reflected in this fund group’s average 1.92 percent expense ratio. By contrast, the average expense ratio for a U.S. Large Blend Equity Mutual Fund is 1.09 percent, or roughly half.
2. Spotty performance and murky strategies. Results for market-neutral funds varied widely in 2008, with some funds losing more than 30 to 40 percent, and a few gaining an impressive 7 to 10 percent (before fees). The range reflects the different strategies managers employ to try staying neutral—strategies that can be hard to uncover. Morningstar analyst Michael Herbst says most strategy details he has unearthed came not from prospectuses but from talking to fund managers. “Lack of transparency is a concern,” he notes.
3. Tax wallops. Constant rebalancing within the fund produces a high portfolio turnover — 350 percent, on average, for these funds. Since you could be socked with capital gains on the frequent sales, these funds may be better suited for tax-sheltered retirement accounts.
4. High minimums. Many of these funds require $10,000 to $25,000 to invest, though some accept as little as $1,000.
The Bottom Line
Though market-neutral funds can provide diversification for a small part of your portfolio, their lack of transparency, their wide range of returns, and their high expenses make them a dubious choice.
“I don’t want to swear them off completely — there are some managers we think highly of — but most investors don’t need them,” says Herbst. “You can’t have a reasonable set of expectations for knowing how they will perform. I’m not convinced they’re a better instrument than regular bonds at this point.”
What They Are
These funds use a wider array of hedging strategies than their market-neutral brethren. They can move into currencies, real estate, bonds, international investments, managed futures, cash, and derivatives, as well as take offsetting long and short positions. The name “absolute return” is something of a misnomer. The funds don’t guarantee you’ll never lose money; the “absolute” label merely denotes that the funds differ from standard “relative return” funds, which seek to outperform benchmarks like the S&P 500. Comparing absolute-return funds is tricky. At Morningstar, 15 funds include the word “Absolute” in their names, but the funds belong to different categories, so you can only screen for them by name.
Through hedging, these funds seek to carve out positive returns while limiting risk.
1. Near-genius required. Investors give fund managers carte blanche to shrewdly use and revise sophisticated strategies in an environment where hundreds of hedge funds have collapsed.
2. Short histories. Absolute-return funds are so new they have no five-year track records. Their three-year average annualized return was a negative 4.14 percent, according to Morningstar. Last year, they fell 11.7 percent on average. That’s far less than the 37 percent drop in the S&P 500, but still not most people’s definition of “safe.”
3. “Absolute” is relative. This January, Putnam introduced four absolute-return funds whose names suggest the specific gain over the Treasury-bill rate they’re aiming to achieve. Putnam Absolute Return 100, 300, 500, and 700 aim to get returns of 1, 3, 5, and 7 percent, respectively, above the Treasury bill rate over “three years or more.” That squishy time frame gives the funds an indefinite period for delivering those returns.
The Bottom Line
While this group will likely outperform stocks in general in a bear market, they’ll lag when the market surges. Given that limited upside, you may find it tough to accept suffering any loss in a downturn.
Stearns Financial Services Group in Greensboro, N.C., analyzed absolute-return funds and market-neutral funds and came away unimpressed. “We have not been comfortable with the fees and expenses,” says Dennis Stearns, the firm’s president. “I’ve participated in a number of think tanks and design sessions over the years, [where] I’ve met many Ph.D. design experts, Dr. Frankensteins who think they’ve figured out the better mousetrap. In my opinion, 99 percent of them are for the birds.”
What They Are
Like other annuities, these are contracts with insurance companies sold by brokerages, insurers, and banks. In exchange for your investment (typically at least $5,000 to $10,000), the insurer agrees to give you periodic payments or a lump-sum payout. You’ll earn a return linked to the investments in an index like the S&P 500, and you’re guaranteed not to earn less than a minimum rate of 2 or 3 percent, even if the index loses money. The return is credited at the end of the annuity’s term, which typically lasts seven to 15 years.
Sort of a “heads you win, tails you break even.” Because these annuities have additional returns pegged to a benchmark like the S&P 500 index, you have the chance to participate in the gains when the market goes up. And since you’re guaranteed a minimum return, you’re protected from a market drop.
1. Upside limits. If the market goes up, most EIAs pay out only a percentage of the increase in the index, maybe 80 percent. Other EIAs cap your potential gain by limiting you to a maximum return of, say, 8 percent in any one year. And EIAs don’t include stock dividends when calculating gains, so you lose out on what could be a major part of a stock’s payoff.
2. Complexity. Good luck figuring out your gain. EIAs use many different and arcane methods to calculate returns.
3. Limited access to your money. Though many EIAs let you withdraw up to 10 percent of your money without penalty each year, you’ll likely owe a hefty penalty (called the surrender fee) to get your hands on the cash before the surrender period is up. Surrender fees can start as high as 15 or 20 percent of the amount withdrawn, and take six to 10 years to disappear. You’ll also owe a 10 percent federal tax penalty if you’re under 59 . Some insurance companies will not credit you with index-linked interest if you don’t hold your contract to maturity — you’ll get only the guaranteed minimum rate.
4. Possible losses. Many insurers guarantee that you’ll receive 90 percent of the premiums you paid, plus at least 3 percent interest. So you can lose money if your guarantee is based on an amount that’s less than your purchase payments. Say you deposited $100,000 in the annuity and a year later the index linked to it had declined but you needed to withdraw your money. With no credited interest from the index, you’ll earn just 3 percent of $90,000, for a total payout of $92,700.
The Bottom Line
Consider buying an equity-indexed annuity, but only with professional guidance from a planner who gets no commission from selling you the contract. EIAs have a history of high-pressure sales, especially to seniors. A growing number of fee-only certified financial planners have expertise analyzing EIAs. To locate one, go to the National Association of Personal Financial Advisors’ Web site, click on “find an Advisor,” then “Refine Results by Specialty,” and choose “Insurance Related Issues, including Annuities.”