The idea seems simple enough: a fund with a set return no matter what the financial markets do, up or down. You can get steady interest earnings, of course, with bank savings or a bond, but will have to settle for a low yield.
Dependable return is very hard to achieve if you want to earn much more.
That’s where “absolute return” funds come in. Also called target-return funds (not the same as target-date funds), these pools typically set a goal of 4 percent return on top of yields earned in cash like bank savings, or 5 percent on top of inflation, according to Morningstar.
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“This is a particularly important time to be discussing absolute-return funds, as the market has been reaching ever-higher levels of valuation,” says S. Michael Sury, chairman of Indorus Holdings, a wealth-management firm, and an adjunct professor of Financial Economics at the University of California. “Investors would be wise to consider funds that can provide at least some protection from inevitable market corrections.”
Most investors are more familiar with “relative-return” funds that strive to beat a standard benchmark like the Standard & Poor’s 500 index.
“Most mutual fund managers set a goal of beating a benchmark such as the S&P 500 index,” says Craig Misuradze, president of Agewise Financial, an investment advisor in Palm Desert, California. “In this regard, a manager could consider a 35 percent loss in 2008 a success because he beat the benchmark. Undoubtedly, most investors in or approaching retirement would not agree.”
“Absolute-return funds are often given the leeway to depart from a particular benchmark index or style when that benchmark begins to turn negative,” Sury says. “In so doing, these funds hope to protect capital when markets are down.”
In some respects absolute-return funds are like hedge funds for ordinary investors, and they become popular after stock market crashes, Sury says. These funds can use short selling, bets on futures contracts and derivatives, leverage and other techniques not used by standard stock and bond funds.
“Absolute-return funds are ideal for individuals who want slow and steady annual growth without a lot of volatility,” says Rich Winer, wealth advisor at Steel Peak Wealth Management in Woodland Hills, California.
“(Investors) should not expect to keep pace with the S&P 500 in a strong market year, but they will sleep well at night knowing the value of their investment will not be bouncing around with the stock market,” Winer says. “They can also feel comfortable knowing that the value of their investment should not drop anywhere near as much as the overall market in a severe stock market decline or bear market.”
Winer cites Catalyst Hedged Futures Strategy (ticker: HFXCX), pointing to its 49 percent gain when the S&P 500 dropped 37 percent in 2008.
But long-term investors should think carefully. Last fall Morningstar evaluated 38 of these funds, finding that 15 produced positive returns over all three-year periods since their inception, despite some stock market downturns along the way. Twenty-nine produced positive returns in more than 80 percent of the three-year periods.
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But the survey also found that portfolios of 30 percent stocks, 70 percent bonds, as well as ones with a 50-50 mix, also had positive returns in all three-year periods over the previous decade. Morningstar noted it was a tough contest because stocks had done so well during that period. Absolute-return funds are designed to shine in downturns.
So, do absolute-return funds really have an edge over the alternatives? One of their main goals is to protect against losses in down markets, but Morningstar found the two stock and bond portfolios did this better, concluding that “target-return funds have turned in rather disappointing results.”
“Absolute-return funds with low correlation to the broader markets can dampen overall portfolio volatility,” Sury says. “However, such funds can underperform in rising markets while still participating in at least some of the downside. As a result, such funds have generally delivered mediocre and unsatisfying results to investors.”
Part of the problem is high fees the funds charge to implement their strategies, with 2 to 3 percent being common, according to Sury.
Still, Morningstar found some of these funds worth recommending, including GMO Benchmark-Free Allocation ( GBMFX) and JHancock Global Absolute Return Strategies ( JHAIX).
Experts say absolute-return funds are best for the investor with a known spending need in the future such as college tuition, or for retirees trying to avoid losses when markets turn sour.
With stocks at record highs after a long bull market, the odds of a correction or steeper decline may seem high to many investors.
Misuradze says: “More than ever, investors are taking to heart Warren Buffett’s two rules of investing: Rule No. 1: Never lose money. Rule No. 2: Never forget Rule No. 1. It may not be possible to never lose money, but for many, minimizing losses has never been more important. Additionally, the standard investment line ‘past performance is not indicative of future results’ has never been more true than it is today.”
But absolute-return funds do require a tradeoff, Winer says.
[See: U.S. News & World Report’s 10 Top-Ranked ETFs.]
“If you want high returns in each and every year, an absolute-return fund would not be appropriate,” he says. “You will be disappointed in years when the market is up 10 to 15 percent and your absolute return fund is up only 5 percent.”
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Target-Return Funds an Option for Some Anxious Investors originally appeared on usnews.com
