Investors would love to be able to achieve positive returns in both bull and bear markets, and that’s the “promise”—or at least the premise—of absolute-return funds.
The devastating bear market of 2008 increased the demand for these funds. Wall Street is happy to meet that demand with its usual array of high-cost vehicles. In 2000, absolute-return funds had $2 billion in assets under management.
By the end of 2010, that figure had grown to $25 billion. Thus, it’s clear that investors believe—or are conned into believing—that absolute-return funds are likely to achieve their objectives.
Absolute-return funds try to accomplish their objective using a wide variety of strategies. While some absolute-return funds invest primarily in stocks and bonds, others use commodities, short selling, futures, options and other derivatives, arbitrage strategies, currencies, credit risk, leverage and almost anything else you can dream up.
That’s one of the many problems with these funds—you just don’t know what they own and what risks you’re exposed to. The question for investors is this: Despite these issues, are absolute-return funds likely to achieve their objectives? The authors of the study “Do Absolute-Return Mutual Funds Have Absolute Returns?” published in the winter 2013 issue of The Journal of Investing, sought the answer to that question. The following is a summary of their findings:
The authors concluded: “Investors seeking absolute returns using mutual funds are likely to be disappointed.” In other words, via the high fees charged, the sponsor’s objectives were met. It’s just that the objectives of investors weren’t.
The evidence from this study adds to the evidence on the poor performance of absolute-return funds. For example, a study in the April/May 2012 issue of the Morningstar Advisor found that of the 25 absolute-return funds that were launched before 2011, just 9 (36 percent) provided positive returns. And this occurred during a year when the S&P 500 Index, the Russell 3000 and all major bond indices produced positive returns!
This was virtually the same result that occurred in the 2008 bear market, when just nine of the 26, or 35 percent, absolute-return funds generated positive returns. Morningstar also noted that the absolute-return funds that use a long/short strategy—the idea is to have no exposure to the overall risk of the market—still managed to lose an average of 15.4 percent in 2008. While that’s better than the market’s loss of 37 percent, it’s not even close to an absolute return.
We can also look at the results of vehicles that use absolute-return strategies by examining the data provided by hedgefundresearch.com.
The Hedge Fund World
In 2013, the HFRX Absolute Return Index returned 3.6 percent. In 2012, it barely broke even, returning just 0.9 percent.
And despite the term “absolute return” in the name, the HFRX Absolute Return Index managed to lose 3.7 percent in 2011, the fourth consecutive year of losses. The index lost 0.1 percent in 2010, 3.6 percent in 2009 and 13.1 percent in 2008. Each $1 invested in the index at the start of 2008 would have been worth slightly more than $0.84 by the end of 2013. And that’s not even accounting for inflation.
Thus, we can conclude that absolute-return funds have demonstrated the ability to lose money in both bull and bear markets. The only thing absolute about these funds is how absolutely bad they are. And while mutual funds that use absolute-return strategies are expensive, they’re cheap by hedge fund standards, with their typical fee structure of 2/20 (2 percent annual fee plus 20 percent of the profits).
The conclusion we can draw is that the so-called advantage that absolute-return funds have in the form of the freedom to choose from a wide range of investments doesn’t translate into real world benefits. The reasons are that their strategies are costly to implement and the market is highly efficient at setting prices.
The bottom line is that no one should invest in absolute-return vehicles, because they aren’t absolute-return vehicles, but relative return vehicles. They are just another way Wall Street has found to transfer money from your wallet to its.