Why many absolute return strategies are destined to fail.
Any rational investor prefers positive returns in both bull and bear markets. Absolute-return mutual funds, which have been around since 2005, promise just that: positive returns regardless of market conditions. The 2008 financial crisis increased the appeal of the absolute-return idea so much that 21 new absolute-return funds were launched post-crisis, bringing the total to 37. Since 2008 these funds have raised an astounding $17.3 billion.
The rapid growth of assets does not validate the absolute-return idea itself, however. The recent performance of absolute-return mutual funds has sorely disappointed. Only six of 27 funds incepted earlier than 2011 have managed to post positive year-to-date returns through Sept. 30. Beyond the numbers, though, it is useful to examine the underlying strategies used by absolute-return funds as well as the drivers of their disappointing performance. Are the strategies theoretically sound but poorly executed? Or was the plan flawed to begin with? A review of their prospectus investment strategies, holdings data, and correlations statistics indicates that, unfortunately, the latter might be the case.
The Underlying Strategies of Absolute-Return Funds
In order to deliver absolute returns, a portfolio manager needs to achieve two goals. First, he must be able to protect principal from market risk. Second, he must generate positive returns (even a small percentage) at all times. This is a very strict definition, but if an absolute-return fund is allowed to lose money in the near term with the hope of generating longer-term gains, any investment strategy can be called "absolute return."
The actual strategies created to meet absolute-return goals range broadly, from plain-vanilla long short equity to complicated derivatives trading. But, in essence, they can be broadly categorized into three buckets.
Some absolute-return managers choose to play in the equity arena. Unlike traditional long-only stock funds, which succeed if they lose slightly less than the market, most absolute-return stock funds employ a long-short approach and attempt to make money in both bull and bear markets. By hedging equity movements using index derivatives or exchange-traded funds, the manager can lower the volatility of his portfolios and hope to protect principal. By shorting, the strategy can in fact profit in down markets.
Variations of this strategy reflect managers' thoughts on how to achieve the goal of absolute returns. Nakoma Absolute Return
Debt and Currency Strategies
Admitting that the equity market is volatile, some absolute-return managers see more opportunities in the fixed-income world, where high-quality bond offerings are considered safe havens to protect the principal and generate interest incomes. Sovereign-debt investing is a popular theme within these funds. Eaton Vance Global Macro Absolute Return
Some absolute-return funds give their managers great freedom to choose from a wide range of investment products, from traditional equity and bonds, to currency forwards and asset-backed securities. Geographically, these funds have no boundary either. Managers can go anywhere they see opportunities. The hope is that, if a fund manager is truly skillful, more investment options should provide a bigger platform to generate alpha, or outperformance. Additionally, allocation among various asset classes and world markets may help with diversification. Sometimes, these go-anywhere funds are structured as funds of funds or a fund of multiple subadvisors. For example, Absolute Opportunities