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Absolute Return Funds Fail the S.A.M.U.R.A.I. Test

Their benchmarks lack honor. 

Jason Kephart, 05/15/2017

Absolute returns are a popular goal among mutual funds, but investors considering these funds need a better benchmark. We’ve previously covered how funds that target positive returns have generally delivered on the absolute return promise over the past 10 years, but so have traditional asset-allocation funds. You can find that research here. In this piece, we’ll measure whether using “absolute returns” as a benchmark makes sense, by using what’s commonly referred to as the S.A.M.U.R.A.I test. This is a mnemonic device for seven criteria that a valid investment benchmark should meet.

First, a primer on the allure of absolute, or target, return funds. From an investor standpoint, focusing on a target returns makes sense if there are clear spending needs on the horizon. For example, imagine Sam and Rosie Gamgee, who want to fund their child's college education using their investment portfolio without dipping into the principal. With the help of their financial advisor, they decide that a portfolio return of 5% above inflation would meet that goal. In theory, an investment strategy that can provide a minimum return of inflation plus 5% annualized would be ideal.

That’s where one of the more than 80 mutual funds that target absolute returns, rather than returns relative to a static benchmark, might come in handy. Although these funds share the similar outcome-oriented goals, they cover a wide range of investment strategies. Most of these funds, like William Blair Macro Allocation WMCJX and AQR Style Premia Alternative QSPIX, fall into alternative categories. Others, like GMO Benchmark-Free Allocation GBMFX, fall into traditional allocation categories. Because these target-return funds have similar goals, it may be tempting to solely judge them based on if they hit their target returns over a specified period, usually three- or five-year rolling periods. Before jumping to that conclusion, let’s see how target returns do with each of the seven requirements of a valid benchmark as defined by the S.A.M.U.R.A.I. test.

Specified In Advance--Pass
The first requirement of a valid benchmark is that it is specified in advance. We’ll give target-return funds credit for this one, even though some managers make investors work harder than others to find out what the actual target return is. Putnam Investments wins the award for the most transparent target-return funds in this sense, as the four target-return funds it offers have target-return above cash in the fund names. Putnam Absolute Return 500 PJMYX, for example, targets returns of cash plus 5% over rolling three-year periods.

Appropriate for the Manager’s Style and Constraints--Fail
Most reasonable investors would agree that it doesn’t make sense to judge a large-cap value fund’s performance versus a large-cap growth index. Absolute returns don’t have a style because they are literally just a number, but target-return managers can, which means they can fall short of their goal or overshoot it based on whether that style of investing is in favor. When measuring a manager, it is important to separate beta--that is, market or factor returns that an investor can purchase cheaply in an index fund--from alpha, which is a sign of manager skill and much more scarce.

Of the target-return fund managers, some fall firmly in the value investor camp, like GMO Benchmark-Free Allocation and JHancock Global Absolute Return Strategies JHAIX, while others like AQR Style Premia Alternative use a mix of factors including value, momentum, and low beta. Despite the different styles, each fund targets returns of at least cash plus 5%.

Because styles can go out of favor for extended periods of time, these tilts can have an adverse effect on performance over short- or medium-term periods. GMO’s value bias, for example, has led to a defensive portfolio that has lagged peers over the trailing five years as stocks and bonds have rallied. Over the five years ended March 31, that fund returned 3.9% versus 1.2% for the US Bureau of Labor Statistics CPI All Urban Not Seasonally Adjusted Index, giving the fund an absolute return of about half its bogy.

Measurable--Pass
Provided the fund states its target return in advance, it is very easy for an investor to measure if it has hit that goal over various time periods.

is an analyst covering alternative strategies on Morningstar’s manager research team.

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