Saturday, January 22, 2011

Marketwatch's Chuck Jaffe - Absolutely No Reason to Buy 'Absolute Return' Funds

An interesting article yesterday by Chuck Jaffe at deriding the absolute return strategy of mutual fund.  I would argue that his points are misguided because he is not capturing the essence of the strategy, but of course I am biased.  Ironically, if his thesis is correct there should be no reason to buy any hedge fund because in theory they are all (or mostly ... by definition) supposed to be absolute return funds.

Alternative investment strategies such as long-short or absolute return are still only a tiny fraction (perhaps 200 of 8000+ funds) of the marketplace, but exploding in popularity since 2008, after a decade of losses in the industry.  [Feb 5, 2009: Mutual Funds Have Tough Decade The great irony of course is "balls to the walls" long only traditional mutual funds have blasted any sort of hedged mutual fund since March 2009.

The main fault in his argument is that he believes an absolute return fund should "make a positive return in any market", or at least that is how he thinks they are being marketed. 

Absolute-return strategies purport to produce a positive return in all market conditions, no matter the direction of the market.

I don't know how they are being marketed but I do know you can't promise your fund can make any sort of future return in advertisements.  So I am not sure why he thinks fund families are saying they will make positive returns in all market conditions.

But the bigger problem is "making a positive return in all market conditions" is not what absolute return means.  It is essentially defined by a return (positive or negative) independent of a benchmark.  Of course in a perfect world that return would always be positive, but aside from Jim Simons at Renaissance Technologies, I don't think anyone is pulling that off.   Hence, absolute return is simply a return independent of a benchmark, while relative return is a return versus a benchmark.  Framed that way, Chuck would have a lot less ire towards the subject. :)

But let's see his main thoughts:
  • Investors absolutely want to make money regardless of the direction of the market.  That’s precisely why “absolute return” funds are one of the hottest and fastest-growing areas of the mutual fund world.  But just because something is easy to market to the public doesn’t mean it’s a good idea. 
  • The problem with absolute-return funds is not just how they are being sold, but how they work — or fail to — for the typical investor.  Absolute-return strategies purport to produce a positive return in all market conditions, no matter the direction of the market. (Mark's note - not in my world)  They typically try to do this by investing some of the portfolio in cash or low-volatility investments, and then taking long and short positions that, when combined, should deliver results that don’t really correlate to what’s happening in the broad market. (that is correct, but a different goal than the previous sentence)
  • The basic idea is preservation of capital. (agree) In down markets, the funds protect the investor, and in up markets they don’t keep up with the broad market, which is the price the investor is willing to pay in order to get their “absolute return.”  (again, correct)

Now this is where the story gets off the tracks:
  • The average investor couldn’t explain this strategy; what they hear is that they get an “absolute return,” which they take to mean a steady gain under all market conditions, something safe and secure, like a long-term certificate of deposit paying an oversized yield. 
I am not sure how he knows what the average investor is thinking, but apparently it is a Vulcan mind trick of some sort.  There is no strategy that involves stocks or bonds not named "money market" that is 'safe and secure'.  (heck even money markets broke the buck in 2008!)

  • In fact, Putnam Investments has a suite of absolute-return funds, the 100, 300, 500 and 700 series, all of which try to do their job by number. The 100 fund, for instance, “seeks a positive return that exceeds the rate of inflation, as reflected by Treasury bills, by 1% over a reasonable period of time, regardless of market conditions.” The 700 fund tries to do the same job, except that it expects to beat inflation by 7%.  Here’s the problem: If you think that each fund can deliver its absolute return, there’s no reason not to just go for the riskiest fund with the biggest return, the 700. After all, the return is “absolute.” 

Again, if an investor thinks that, then this investor better head over to a RIA to let them invest his/her money.

  • ....the average fund with the words “absolute return” in its name was up 3.34% in 2010, according to Morningstar Inc., compared to the 15% return from the Standard & Poor’s 500-stock index.  On the flip side, the average fund that had absolute return in its name in 2008 — and there were only about a dozen of them — lost 12.7% compared to a market loss of 37%.
Hence the 'average' absolute return fund provided a net positive return over the 3 year cycle of 2008-2010, without the huge drawdowns in 2008 that caused panic attacks and sleepless nights.  Further, knowing how human psychology works many humanoids pulled money out of the market between fall 2008 and early spring 2009 - at the market's lows.  If they had done this in a normal mutual fund they would probably sold at a trough of -40 to -50%.  If they had done it in the 'average' absolute return fund, they would have locked in a 12.7% loss.   Hence, 2 years later people looking back at their sales in late 2008, early 2009 in a traditional mutual fund are kicking themselves for locking in massive losses, whereas those who panicked in an absolute return fund took some losses, but not traumatic.  Making up 10-15% loss is a lot easier than 45-50%.  [Jan 15, 2010: WSJ - Despite Stellar 2009, Only 3% of Stock Mutual Funds are Positive Since 2008]

  • While the funds did their job in a down market, they still posted losses — which hardly seems an “absolute return” — and the typical investor would have walked away from that experience feeling let down by the fund. 
Again, it's all in your definition of absolute.  I don't think it is being sold as "only gains each and every year", but I guess we'd have to sample 500 investors for their view of it.  
  • What’s more, if the strategy works, it will still be disappointing enough of the time so that most investors will not be able to stick with it
That once more goes to human psychology.  Just as investors tend to panic at bottoms, they also tend to performance chase and lose interest if "Balls to the Walls Fund" is making 32% annual for 2 years - while their fund is 'plodding' along at +12% those 2 years.  Then just as they move their monies to "Balls to the Walls Fund" that fund suffers a -40% year.  At which time they of course sell...

So I could make the same argument that investors will be disappointed in "Balls to the Walls Fund" during the now Fed created bubble crashes every 5-6 years.

Anyhow, an interesting discussion.  With some of the big boys like Blackrock moving hot and heavy into these alternative strategies I'll have to look at their ads closely - but I sincerely doubt any of them say "our fund only goes up! Absolutely!"

[June 11, 2010: CBSMarketwatch - More Investors Turn to Flexible Mutual Funds
[Nov 24, 2009: Bloomberg - Investors Rushing into Alternative Mutual Funds
[Nov 12, 2009: WSJ - More Mutual Funds Attempt to "Time" the Market
[Aug 4, 2009: WSJ - Mutual Funds Try "Hedge" Approach in Effort to Trim Stock Losses]
[Apr 10, 2009: More Stock Mutual Funds Declare Cash is King]

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