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Why Absolute-Return Funds Fail to Deliver

Because of flaws in their strategies, many funds are destined for the dustbin from the get-go.

Terry Tian, 04/03/2012

This article originally appeared in the April/May issue of MorningstarAdvisor magazine.  To subscribe, please call 1-800-384-4000.

A rational investor prefers positive returns in both bull and bear markets. Absolute return mutual funds promise just that: positive returns regardless of market conditions. The 2008 financial crisis increased the appeal of the absolute return idea so much that 28 absolute return funds were launched postcrisis, bringing the total to 41. Since 2008, these funds have raised an astounding $11.1 billion.

The rapid growth of assets does not validate the absolute return idea itself, however. The recent performance of absolute return funds has sorely disappointed. Only nine of the 25 funds started earlier than 2011 managed to post positive results last year. Beyond the numbers, however, 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? 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
To deliver absolute returns, a manager needs to achieve two goals: protect principal from market risk and generate positive returns at all times. This is a strict definition, but it’s required because if we allow an absolute return fund 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.

1. Equity Strategies
Unlike managers of traditional long-only stock funds, which succeed if they lose slightly less than the market, most managers of 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, managers can lower the volatility of their portfolios and hope to protect principal. By shorting, the strategy can even, 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 (which was merged into Schooner Global Absolute Return SARIX in November) kept the same amount of assets on both the long- and the short-equity portfolios and aimed to produce positive returns through stock-picking. WBI Absolute Return Dividend Growth WBDGX targets absolute returns by investing in long-only high-quality stocks that pay dividends. Most of these equity absolute strategies have a broad geographic focus, betting the global stock markets do not move like a herd.

Terry Tian is an alternative investments analyst at Morningstar.

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