'Absolute-Return' Funds Aren't So Definite

By Jane Bryant Quinn
Sunday, March 1, 2009

Gather round, children, to hear about the investments you've been waiting for. They suggest that you might get positive returns in any economic climate, regardless of whether stocks are going up or down.

Wait -- don't run! It's not Bernard Madoff or even R. Allen Stanford, the mini-Madoff accused of bilking savers out of $8 billion in supposedly high-rate certificates of deposit. This one's sanctified by hedge funds and brought to you by America's finest financial engineers.

I'm talking about the mutual funds whose investment strategies aim to be "market neutral" or to deliver "absolute returns." Morningstar, which publishes fund data, has 28 of them on its list, up from a handful five years ago.

Putnam Investments jumped into the ring in January, with four absolute-return funds for retail investors. Goldman Sachs Asset Management started one last May, and the Natixis Funds launched its in October. The products are pitched at frightened people seeking Wall Street's holy grail: low-risk investments that can yield attractive returns. But what's the reality, as opposed to the hype?

Market-neutral funds typically take long positions in stocks and balance them with short positions of roughly equal value and in similar assets. In a falling market, gains on the shorts are supposed to offset losses on the longs and add extra value if the shorts were chosen well. In a rising market, the longs are supposed to outperform the shorts. Some funds trade on technical anomalies among stocks. In either case, the managers aim to make money in any market, with returns exceeding the interest rate on Treasury bills.

Absolute-return funds use a wide variety of hedge-fund strategies intended to deliver attractive (not super) returns while limiting risk. Besides long/short positions, their holdings might include commodities, currencies, international investments, real estate, managed futures, cash, bonds and derivatives.

Putnam's funds go out on a limb by suggesting a specific gain over the Treasury-bill rate. There's Absolute Return 100 (1 percentage point more than Treasury bills), Absolute Return 300 (3 points over), Absolute Return 500 (5 points over) and Absolute Return 700 (7 points over).

Putnam expects to deliver these positive returns over "three years or more," regardless of market conditions. Color me skeptical, especially after considering the expenses on the aggressive funds. Of course, there's a lot of wiggle room in the phrase "or more."

You can also color me amazed. Putnam is floating specific, future returns that, while not guaranteed, are highly suggestive for marketing purposes. Robert Reynolds, Putnam's chief executive, says the managers of the new funds have been getting those kinds of results for institutional clients. "Over a three-year period, I'm highly confident that these returns will be met," he says.

The Putnam prospectus discloses that a simulacrum of Absolute Return 500 lost 7.57 percent over the past year, so the strategy has a lot of ground to make up. It helps that Treasury bills are low now.

The Goldman Sachs Absolute Return Tracker fund and Natixis ASG Global Alternatives fund take a different approach. You might call them synthetic hedge funds. They're designed to copy average hedge-fund returns for much less than hedge-fund costs.

How have these sectors performed? I'm sorry you asked.

Morningstar finds that both Treasury bills and short-term bond funds outperformed market-neutral funds over the past one-, three- and five-year periods. For a low-yield investment that reduces portfolio risk, Treasury securities and short-term funds appear to be a better choice.

Morningstar analyst Michael Herbst describes market-neutral funds as "delivering bond-like returns but carrying equity-type risks." For this reason, he's doubtful about them as a group.

The average absolute-return fund lost 13.2 percent over one year and 5.8 percent annually over three years, by Morningstar's count. In general, they've been less risky than all-stock funds, fulfilling their charter. But they don't produce positive (or near-positive) returns in all kinds of markets, as some investors expected.

Morningstar also looked at a traditional 60/40 portfolio -- 60 percent stocks, 40 percent intermediate-term bonds. It lost 24.1 percent last year, almost twice as much as the absolute-return funds. But that portfolio outperformed absolute-return funds in the rising markets of 2006 and 2007.

Jay Compson, co-founder of Absolute Investment Advisers in Hingham, Mass., thinks 60/40 portfolios won't be good enough in the future. "Two asset classes aren't enough to minimize volatility," he says. The hedge-fund difference, if successful, lies in its short positions as well as its non-traditional investments.

Still, you can't count on absolute-return funds to get it right. Some lost as much as 30 percent last year, and hundreds of hedge funds have collapsed.

The managers' skill is critical, says Andrew Lo, director of the Laboratory for Financial Engineering at the Massachusetts Institute of Technology. For individuals, "it's hard to know if you have a good manager or a mediocre one who's just chewing up trading costs and expenses," he says.

Alternative funds charge investors much more than they'd pay for traditional investments, and for what? That's the question asked by Larry Swedroe, a principal at Buckingham Asset Management in St. Louis, Mo., and author of "The Only Guide to Alternative Investments You'll Ever Need." As a group, hedge funds underperformed every major asset class through the market cycle running from 2003 through 2008, he says.

Swedroe calls them "a triumph of marketing;" Putnam's Reynolds calls them "the future of the industry." You be the judge.

Jane Bryant Quinn, author of "Smart and Simple Financial Strategies for Busy People," is a Bloomberg News columnist. Alexis Leondis contributed to this column.

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