Investors, beware: 'absolute return' can mean loss

BOSTON -- Absolute return funds sound like they would stand above criticism. They're the mutual fund industry's latest push to deliver modest, but steady, gains whether stocks are up or down.

The appealingly named products are hot sellers. Investors poured more than $7 billion into the funds this year, according to fund industry researcher Strategic Insight. The total intake through the end of July was more than double the total for all of 2009.

Yet the challenge of performing as advertised is proving tougher than expected.

It's easy to understand why the funds are appealing. Their goal of steady-as-she-goes returns is a draw for investors shaken by the market swings of the last few years. And with baby boomers retiring in huge numbers, wealth preservation and steady income generation are in.

Absolute return funds give average investors access to "market neutral" strategies -- which should succeed in an up or down market -- and other techniques that hedge funds pioneered to cater to wealthy clients. Fund managers get plenty of leeway, but generally take an opposites-attract approach. That is, they load one part of their portfolio with more conventional stocks or bonds, and the other with alternative fare. That can include options, futures, currency hedges, or "short" bets that certain stocks will lose value.

When the conventional side rises or falls, the rest of the portfolio is supposed to move in the opposite direction. This is intended to balance out the fund's performance, but slightly on the positive side. They're called "absolute" funds because they try to hit specific targets -- say, returns of a few percentage points above what Treasurys would yield. That's in contrast to the more common "relative return" funds that seek to outperform benchmarks like the Standard & Poor's 500 index.

Five years after the first fund with "absolute" in its name hit the market, there are now 21, and many others use absolute return strategies to some degree. Although more such funds are in the pipeline, the category's performance is already falling short of expectations in many instances. Their record may come as a surprise to anyone who doesn't read the fine print. Make no mistake, investors can lose money.

Some examples:

-- In the category's brief history at least seven absolute return funds launched and have already ceased operations. Compared with 21 survivors, that's hardly an enviable record.

-- The handful of funds with a five-year record have posted an average annual loss of 0.6 percent, according to Morningstar. Over three years, it's only slightly better, up an average 0.7 percent.

-- Strategies vary widely, despite their similar investment objectives. They also may be predominantly stock or bond funds, which will impact returns. Witness that Eaton Vance Global Macro Absolute Return (EAGMX) boasts an average annual return of more than 7 percent over its three years. But UBS Absolute Return Bond (BNRAX) is averaging a loss of more than 7 percent over three years. Another relative old-timer, Nakoma Absolute Return (NARFX), is averaging a loss of 3 percent over three years.

-- As designed, the funds protected investors when stocks tanked in 2008 and early 2009. But their safety wasn't as great as their names would suggest. As the market was heading toward a bottom in early 2009, absolute return funds lost an average of nearly 12 percent over the prior 12 months, while the S&P 500 was down 38 percent.

-- Over the past 12 months, the funds have rebounded, with an average return of 4 percent. That's in line with how the funds are supposed to perform. Although they're not designed to match market performance, the S&P 500's nearly 11 percent gain over the same 12-month period probably left many absolute return investors wishing they'd stuck with more traditional funds, at least for the short-term.

That performance gap illustrates a challenge for the funds during the next market rally. History shows that investors chase hot returns. They exit safety-oriented products like absolute return funds and get into stocks just as they're are about to peak.

Absolute return funds will lose appeal quickly during the next bull market, predicts Rob Ivanoff, president of Financial Products Research.

Of course, the funds would look pretty good if stocks tank again. Either way, Geoff Bobroff, who runs another industry consulting firm, Bobroff Consulting, worries that absolute return funds could have a tough time executing their complex strategies if notoriously fickle individual investors rapidly move cash in or out.

That rapid movement makes it more difficult for a manager to maintain a desired asset allocation within their fund portfolio. If too many investors withdraw from the fund, they have to sell off investments. This selling or buying to keep the fund's assets in balance might not prove difficult for a fund manager with plenty of experience in absolute return strategies. But Bobroff worries that upstarts could run into trouble, particularly if the economy turns, and the Federal Reserve begins raising interest rates.

The could force many absolute return fund managers to rearrange their portfolios to meet their investment return targets, since many of the funds have large holdings in bonds and other investments sensitive to rate changes.

But some say such fears are misplaced. Rob Bloemker, Putnam Investment's fixed income chief and co-manager of two of Putnam Investment's four absolute return funds, says the Boston company has successfully used absolute return strategies for nearly a decade for institutional clients.

Putnam requires its funds to stay highly liquid, with plenty of assets that can quickly be sold or otherwise be converted to cash. It's designed to ensure the funds can ride out a variety of market conditions, and surges of money coming in or out.

It's still early for Putnam's four funds, but they've been performing as intended. They're designed to achieve annualized returns from 1 percent to 7 percent greater than those of T-bills. Over the past 12 months, the four have delivered returns ranging from about 2 to 5 percent.

Absolute return, Bloemker predicts, will have staying power for an investing public tired of stocks' bumpy results: "I think this category will, through time, prove to be superior."

Others, such as Bobroff, say it's too early to predict whether absolute return will become a durable strategy.

Retirement-oriented investors "clearly have been rattled by two bear markets in the past 10 years," he says. "But I'm just not sure this is the right product, or at least a product that people should be putting all their marbles in."