Why You Should Absolutely Avoid Absolute Return Funds

Last Updated Sep 21, 2011 10:09 AM EDT

There's an old saying that if sounds too good to be true, it almost certainly is. That warning applies to absolute return funds.

While most actively managed funds try to beat a benchmark (such as the S&P 500 Index), absolute return funds aim to deliver gains whether markets rise or fall. They try to accomplish this objective using a wide various strategies:

  • Stocks
  • Bonds
  • Commodities
  • Short selling
  • Futures
  • Options and other derivatives
  • Arbitrage strategies
  • Leverage
  • Almost anything else you can dream up
That's one of the many problems with these funds -- you just don't know what they own and what risks you're exposed to.

Unfortunately, there are many other problems, starting with the fact that the term absolute return is an oxymoron -- the only absolute return investment is Treasury bills. Unfortunately, by preying on their fears, investors who suffered greatly during the bear market of 2008 and early 2009, were easy targets for Wall Street to exploit by creating and marketing a product that's the equivalent of "snake oil." Here is what Morningstar alternative-investment strategist Nadia Papagiannis had to say about them in April: "The name 'absolute return' implies positive returns in any market environment, regardless of strategy. That mandate is very difficult. We haven't seen anybody do it."

According to Morningstar, there were four funds with "absolute" in their title in 2005. Now, there are more than 30. Do absolute return funds justify such faith?

We can look at the results of vehicles that use absolute return strategies by examining the data provided by hedgefundresearch.com. The HFRX Absolute Return Index managed to lose 13.1 percent in 2008 and another 3.6 percent in 2009. As further proof of their inability to generate absolute returns, they again lost money in 2010, though the loss was smaller this time at just 0.1 percent. The only thing absolute about these vehicles is perhaps how absolutely bad they are.

And it's not just the lousy returns, nor the lack of transparency. These funds don't come cheaply. You have to pay dearly for bad performance -- expense ratios run from less than 1 percent to as high as 3 percent. Add to that the problem of tax inefficiency. Because most trade so often, the funds are not only likely to trigger higher capital gains distributions (if they ever make any money), but a greater share of them will likely be taxed at the higher short-term capital gains rates.

Photo courtesy of Karen Eliot on Flickr.

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    Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.