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Why You Should Absolutely Avoid Absolute Return Funds

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 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.

A Better Strategy If the bear market of 2008 taught you that you have a limited ability to deal with severe prices declines, I offer you another strategy -- one you that will limit the risks of those "black swans." It'll also be one you can implement in a low-cost and tax-efficient way (without any of the costs or risks of active management). I think you'll be convinced that you need absolute return funds as much as you need the proverbial "hole in the head." It's a strategy discussed in The Only Guide You'll Ever Need for the Right Financial Plan. You can call it the "low-beta, high-tilt" portfolio.

For the period 1970-2010, the S&P 500 returned 10.0 percent with a standard deviation of 17.9 percent. The index lost money in nine of those 41 years, with the worst loss being 37.0 percent in 2008. Now consider two alternative portfolios:

  • Portfolio A is 90 percent Five-Year Treasuries/10 percent U.S. small value stocks (represented by the Fama-French Small Value Index).
  • Portfolio B is 80 percent Five-Year Treasuries/20 percent U.S. small value stocks.

Note how the returns for Portfolio A and B were similar to that of the S&P 500 Index (especially B), while the level of risk was cut dramatically, the number of years with losses was cut way down, and the worst case loss was a very small one.

As impressive as those results are, I believe there's an even better strategy -- diversifying the equity risk while keeping the "high tilt" to small-cap and value stocks. So you might diversify it from beyond just US small-cap value stocks to perhaps something like: 50 percent US small-cap value, 35 percent international small-cap value, and 15 percent emerging market value. This would mean you don't have all your exposure in one risk (U.S.) basket. Such an allocation would diversify you globally as well as across the three unique risk factors of beta (market risk), size and value. Helping investors design better investment strategies is just one way a good financial advisor can add value.

The bottom line is that no one should invest in absolute return vehicles. They're just another product designed to be sold, never bought.

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Three ways I can help you become a wiser investor:

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