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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.

2. Debt and Currency Strategies
Admitting that the equity market is volatile, some absolute return managers see opportunities in fixed income, where high-quality bond offerings are considered safe havens to protect the principal and generate interest incomes. Sovereign-debt investing is a popular theme at these funds. Eaton Vance Global Macro Absolute Return EAGMX diversifies among government bonds across the world. American Independent Absolute Return Bull Bear Bond AABBX invests solely in U.S. Treasuries, related ETFs, and interest-rate futures.

Other absolute return managers tactically invest across the interest-rate and credit spectrum and sometimes hold significant cash stakes. In late 2009, Putnam Absolute Return 100 PARTX allocated about 75% of assets to cash to protect against market volatility. Managers of 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 credit risks, many absolute return debt or currency strategies target a relatively short duration, and they may engage in credit-derivatives trading to lower default risks.

3. Go-Anywhere Strategies
Some absolute return funds give their managers freedom to choose from a wide range of investment products, from traditional equity and bonds to currency forwards and asset-backed securities. These funds have no geographic boundaries, either. Managers can go anywhere they see opportunities.

The hope is that more investment options will provide a skillful fund manager a bigger platform to generate alpha. Also, allocation among various asset classes and world markets may help with diversification. Sometimes, these go-anywhere funds are structured as a fund of funds or a fund of multiple subadvisors. Absolute Opportunities AOFOX picks several subadvisors to diversify across various trading strategies.

The Absolute Return Hurdles
At first glance, these absolute strategies all seem plausible, well-positioned to protect investors’ wealth, and ready to achieve positive returns. Investors, however, have good reason to be skeptical. Even considering that absolute return funds have short track records, one can easily see that most of these funds have failed to deliver. Only six of the 13 funds with three-year track records have produced gains over the past one and three years (through December).

These results should not be surprising because the strategies the funds started out with made it very difficult, if not impossible, to achieve their goals. First and foremost, the funds failed to address the fundamental question of absolute return: how to remove the relative market-risk factors in their portfolios. Theoretically, a zero beta can be achieved through a market-neutral strategy, in which all positions are properly hedged. However, most absolute return funds do not even aim to be market-neutral. The result is that their returns are inevitably linked to market performance.

For example, 12 out of the 25 absolute return funds with at least a one-year record showed a correlation to the S&P 500 greater than 0.6 between January 2011 and December 2011 (using weekly data), meaning that more than 36% of the returns could be explained by stock market movements. These results indicate that even though many absolute return funds claim to be uncorrelated with traditional asset classes, nearly half of them still post very equitylike return profiles. Topping the chart in terms of broad equity-market correlation is WBI Absolute Return Dividend Growth, which has a correlation of 0.95 and a beta of 0.83 with the S&P 500 Index. Therefore, the fund’s performance has moved in line with the stock market and has experienced most of its ups and downs.

On the fixed-income side, 11 out of these 25 funds demonstrated a correlation of more than 0.6 with Barcap Global High Yield Index between January 2011 and December 2011. Loomis Sayles Absolute Strategies LABAX exhibited a 0.84 correlation with Barcap Global High Yield Index, which means more than 70% of its returns could be explained by index movements. This is not surprising. Many managers are reaching for yield in such a low-interest-rate environment. Even strategies that do not seek yield or equity growth may still be exposed to market risks. Merk Absolute Return Currency Fund exhibited a 0.66 correlation and a 0.50 beta with PowerShares DB US Dollars Index Bearish UDN, an ETF that can be used to proxy short U.S.-dollar exposure.

The implication of showing high betas and correlations with various types of market indexes is twofold. On the one hand, these investments will move in the same direction as the underlying market indexes, thus failing to protect the principal should that market turn bearish. On the other hand, the positive returns they produce, if any, are not absolute in nature, but rather associated with the benchmarks, and thus are relative returns.

Only six absolute return funds achieved a relatively low correlation (less than 0.5) with all major market indexes, but in doing so, some were unable to produce returns: American

Independent Absolute Return Bull Bear Bond and Absolute Opportunities, for example, lost 9.3% and 3.9%, respectively, in 2011.

Apart from beta and correlation, costs and fees may drag down the returns even further. Absolute return strategies are usually associated with higher expenses compared with traditional long-only investing. To actively position their portfolios, absolute return managers incur big turnover ratios and, therefore, trading costs, relative to traditional managers. Whereas the typical large-blend equity mutual fund sports a turnover ratio of less than 50%, 13 of the 25 absolute return funds with at least a one-year record have exhibited a turnover ratio higher than 100%.

Shorting costs must not be overlooked, either. When managers sell stocks short, they may be required to pay dividends or interest, which might drag down the performance. A couple of the funds had significant shorting expenses per their last annual report.

Lastly, when a fund tries to diversify across a wide range of strategies, it may hire a number of subadvisors or construct a fund of funds, which leads to multiple layers of management fees and, therefore, higher expense ratios. Fifteen out of the 25 absolute return funds’ prospectus net expense ratios (which include acquired fund fees) are higher than 1.5%.

Doomed From the Start
Many absolute return funds failed their investors in 2011. The reason for their underperformance is embedded in their strategies. By taking on exposure to traditional market risks, most are just delivering relative returns, which investors can get at lower costs from traditional vehicles. Even though a few absolute return managers actually hedged their market betas, most were unable to generate positive returns. It turns out that absolute returns are not so absolute after all. 

Terry Tian is an alternative investments analyst at Morningstar.
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