Morningstar Advisor - April/May 2012 - (Page 46)

Spotlight Why Absolute-Return Funds Fail to Deliver By Terry Tian Because of flaws in their strategies, many funds are destined for the dustbin from the get-go. 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 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. 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 46 Morningstar Advisor April/May 2012

Table of Contents for the Digital Edition of Morningstar Advisor - April/May 2012

Morningstar Advisor - April/May 2012
Letter From the Editor
We’re Too Smart
How Do You Use Alternatives?
Taking the Lead
How to Find Economic Moats
The Beauty of Currencies
No Clarity on Bonds
Four Picks for the Present
Investment Briefs
Performance Chasing, Evaluated
Technology’s Slim Pickings
How Much Is Enough?
The Fear Bubble
Three Traits of a Successful Long-Short Equity Manager
Why Absolute-Return Funds Fail to Deliver
An Economist’s Response to Crises
Undiscovered in Plain Sight
Untangling ETF Tax- Efficiency Myths
Central Banks Driving the Gold Rush
U.S. Industrials Could Add Some Magic to Europe-Weary Portfolios
No-Hesitation Allocation Funds
Our Favorite Mutual Funds
50 Most Popular ETFs
Undervalued Stocks With Wide Moats
The Greatest Story Ever Told

Morningstar Advisor - April/May 2012