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Where are the Absolute Returns?

Why many absolute return strategies are destined to fail.

Terry Tian, 03/15/2012

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.

Equity Strategies
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 NARFX keeps the same amount of assets on both the long- and the short-equity portfolios and aims to produce positive returns through stock-picking. WBI Absolute Return Dividend Growth WBDGX diverges from the long-short equity pack, targeting absolute returns by investing in long-only high-quality dividend-paying stocks. AmericaFirst Absolute Return ABRFX also holds over 90% of its assets in long stocks. Most of these equity absolute strategies have a broad geographic focus, betting the global stock markets do not move like a herd.

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 EAGMX diversifies among government bonds across the world, while American Independent Absolute Return Bull Bear Bond AABBX invests solely in U.S. Treasuries and related ETFs. Other absolute-return managers tactically invest across the interest-rate and credit spectrum, and sometimes hold significant cash stakes. For example, in late 2009, the Putnam Absolute Return 100 PARTX allocated about 75% to cash to protect against market volatility. Currency funds, such as Merk Absolute Return Currency MABFX, take advantage of the fluctuations in foreign-currency-denominated cash or short-term-debt instruments. To hedge the interest-rate and/or credit risks, many absolute-return debt or currency strategies target a relatively short duration (a measure of interest-rate sensitivity), and they may engage in credit-derivatives trading (credit default swaps, for example) to lower default risks.

Go-Anywhere Strategies
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 AOFOX picks 13 subadvisors to diversify across various trading strategies.

Terry Tian is an alternative investments analyst at Morningstar.
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