Several mutual fund families have started releasing funds with an objective of ‘absolute returns’. For many individual investors, the selection of mutual funds is often based in part on the name of the fund. Having experienced the returns of the markets during the last two years, finding a fund which promises an absolute return may be appealing.
First and foremost, absolute return is not a guarantee for a positive gain! Most funds that are classified as ‘absolute return’ are funds whose objectives include additional strategies protecting against losses. Some of the strategies may include derivatives, short sells, puts, calls, commodities, and futures. These funds may not be for everyone because of the wide variety of strategies employed by these funds.
Many of these funds attempt to provide a return of X percent greater than U.S. Treasuries. Thus if ‘X’ is one, two, four, or seven percent above U.S. Treasuries, this would potentially create a total return of five to eight percent. A five or six percent positive return clearly is more appealing than a 15 or 20 percent loss. However, before these funds are added to a portfolio, a clear understanding of how they work should be in place.
These funds always allocate a portion of their assets to protect against a market decline. During massive declines such as what we experienced this past year, even absolute return funds were negatively impacted and most showed a loss. This is due to the allocation of part of the assets to protect against the markets moving lower. However, this loss was lower than most equity funds. Additionally, when the markets are moving up at faster than normal rates, these funds may under perform most equities.
Most mutual funds attempt to out perform a specific index. If the index is down 10 percent, the funds benchmark against the index in an attempt to be down less than the index’s loss. When the index is trading higher, most funds are attempting to out perform the index with results higher than the index’s. For absolute return funds, they are not bench marketing against any one index, but instead they are attempting to provide a positive result regardless of the market’s actual direction.
When the market is off five to ten percent, and the absolute return funds are showing a positive three to six percent, I would suspect most investors would be satisfied with the results. However, when the markets move up 15 to 20 percent, and the absolute return funds are up significantly less, I believe many investors will start dumping the absolute returns funds in favor of the traditional mutual fund.
These funds can offer some protection, but they must be employed at the right time. Adding these funds after the markets have fallen through the floor may be a little late. However, making these funds part of the allocation when the markets are nearing past highs may be an excellent strategy.
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