Should You Chase Absolute Returns?

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It’s the holy grail of investing: stock market returns without stock market volatility.

Sure, the stock market has returned an inflation-adjusted 7% annually since 1950. Unfortunately for those of us (i.e., everyone) who would like to watch our money grow steadily year after year like rising pizza dough, some years are like 1998 (up 28.6%!), and some are like 2008 (down 38.5%). That’s not rising dough. That’s a busted seismograph, spewing ink.

In an effort to court investors who are sick of watching their money disappear in a bear market, investment companies offer products that seem to promise less stomach-churning returns. Maybe you won’t get the full return of the S&P 500, the pitch goes, but you’ll reach your destination with much less volatility.

The industry calls them “absolute return” funds, and these hedge fund-like mutual funds appeared in droves after the dot-com implosion of the early 2000s. They go by catchy names like Rydex Multi-Hedge Strategies (RYMSX) and Hatteras Alpha Hedged Strategies (ALPHX).

Now, in the aftermath of the 2008-09 crash, absolute return is back. Morningstar classifies most of these funds in the “long-short” and “market neutral” categories, and money has been pouring in: nearly $16 billion flowed into these types of funds in 2010, up steadily from only $2.7 billion in 2007. Steady returns in any market? Investors seem to be saying, Sign us up.

One of the companies that launched absolute return funds at what in hindsight seems an auspicious time is Putnam Investments. Its Absolute Return family features four funds whose goals are to return 1%, 3%, 5%, and 7%, respectively, above the return on treasury bills, on a rolling three-year basis.

The funds launched in December 2008, and so far they’ve brought in $3 billion in assets and are on track to meet their goals. (Two of these funds, confusingly, are classified as bond funds by Morningstar and the other two, as balanced funds, so their assets aren’t included in the statistics above.)

Putnam says everybody needs a healthy dollop of absolute return in their portfolio. “These products have been in the marketplace for almost two years, and they are ahead of their goals, and we’ve been through some of the most volatile markets that I ever want to experience during that period,” says Jeff Carney, Putnam’s head of global marketing and products.

The company has added the absolute return funds to its target-date funds, its 529 plans, and its retirement income series. “They’re a great product for 529 [plans], because you have a shorter time frame for saving, so you actually want less volatility in your portfolio than you do for retirement,” says Carney.

The big test

So how are absolute return funds doing? The one good thing about the 2008 – 09 Recession was it effectively acted as these funds big test. How did they do on an annualized basis over the last five years?

• Rydex Multi-Hedge Strategies fund (RYMSX): -1.85%
• Hatteras Alpha Hedged Strategies (ALPHX): -0.49%
• JPMorgan Multi-Cap Market Neutral C (OGNCX): -1.17%

• S&P 500 Total Return: +2.4%
• Vanguard Balanced Index Fund (VBIAX, 60% stocks/40% bonds): +4.62%

According to Morningstar, the long-short and market-neutral categories as a whole did somewhat better than these cherry-picked examples. Long-short returned 1.18% and market-neutral 0.9%. In other words, they didn’t even keep up with inflation, and they plummeted in 2008 along with everyone else.

Why should the new generation of absolute return funds be any different? “I think it’s the skill set of the portfolio managers,” says Carney. “I think we’re very fortunate to have a team that’s been doing this for a long time in the institutional space. You don’t want a startup portfolio manager undertaking these things. I can’t speak to the other players in the marketplace and what went wrong and what didn’t.”

Absolute return has, indeed, been a fixture of institutional investing for over a decade. David Swensen, the phenomenally successful endowment manager at Yale, considers absolute return a vital part of Yale’s portfolio. As he explains as politely as possible in his book Pioneering Portfolio Management, however, there are a limited number of David Swensens who are talented enough to make money off this strategy, and most people who attempt to add absolute return to the mix end up receiving a return more like a money market account.

Similarly, Vanguard, not a company known for chasing investment fads, has an absolute return product, the Vanguard Market Neutral Fund (VMNFX). Minimum investment: $250,000. Don’t try this at home, says spokesperson Joshua Grandy. “A large part of our business is comprised of institutional clients, including pensions and endowments,” he says. “This fund is geared to these types of investors who are looking specifically for assets that are uncorrelated to the broad markets to diversify their institution’s portfolios.”

Check the label

Putnam’s funds are unique among absolute return products in that the names of the funds suggest a specific performance target. The prospectus is packed with disclaimers. “The fund may not achieve its goal, and it is not intended to be a complete investment program. The fund’s efforts to achieve lower volatility returns may not be successful.”

If the label says it’s a beef taco, customers expect to find 100% beef in the taco. What about a mutual fund called Absolute Return 700? “That was a big concern of ours and still is, that investors can misunderstand what that number’s actually implying,” says Morningstar fund analyst Rob Wherry. “They’ve put a lot of energy into explaining these things to the advisor community. But certainly, they’re the only funds in the mutual fund world that use that notation.”

“The reality is, it’s just the name of the product,” counters Putnam’s Carney. “And I think by having 1, 3, 5, and 7, we’re making it more clear, really, what the risk and return is of these products in a way that’s very transparent.” He’s not concerned about misunderstandings. “I do not worry about the promissory part, because it’s the fiduciary responsibility of every advisor to make sure clients understand what they bought.”

The problem is, the SEC doesn’t regulate the term “absolute return” the way it regulates, say, a fund with “small cap” in the name, so an absolute return fund can have almost anything in it, and many contain an alphabet soup of derivatives: interest-only swaps, collateralized mortgage obligations, and so on.

“People worry that the word ‘derivative’ means risk. It’s actually hedging the risk,” says Carney. “So it’s used in a defensive way, not an offensive way.”

Individual investors looking to dampen market volatility already have a venerable tool available to them: asset allocation. A defensive mixture of bonds and stocks, such as the Vanguard Retirement Income Fund (VTINX), made it through 2008-09 with less of a plunge than the typical absolute return fund and recovered quickly.

As for the Putnam funds, “We’ve been very vocal in the fact that until they turn three, investors take a wait-and-see attitude,” says Morningstar’s Wherry. “They’re innovative but unproven. And I stress unproven.”

Matthew Amster-Burton is a personal finance columnist at Mint.com. Find him on Twitter @Mint_Mamster.