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Mutual Funds

‘Absolute’ funds more fickle than advertised

By Mark Jewell
Associated Press / August 29, 2010

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Absolute return funds sound as if they would stand above criticism. They’re the mutual fund industry’s latest push to deliver modest, but steady, gains whether stocks are up or down.

The appealingly named products are hot sellers. Investors poured more than $7 billion into them this year, according to fund industry researcher Strategic Insight. The total intake through the end of July was more than double the total for all of 2009.

Yet the challenge of performing as advertised is proving tougher than expected.

It’s easy to understand why the funds are appealing. Their goal of steady-as-she-goes returns is a draw for investors shaken by the market swings of the last few years. And with baby boomers retiring in huge numbers, wealth preservation and steady income are in.

The funds give average investors access to “market-neutral’’ strategies — which should succeed in an up or down market — and other techniques hedge funds pioneered for wealthy clients. Fund managers get plenty of leeway, but generally take an opposites-attract approach. That is, they load one part of their portfolio with more conventional stocks or bonds and the other with alternative fare. That can include options, futures, currency hedges, or “short’’ bets that certain stocks will lose value.

When the conventional side rises or falls, the rest of the portfolio is supposed to move in the opposite direction. This is intended to balance out performance, but slightly on the positive side. They’re called “absolute’’ funds because they try to hit specific targets — say, returns of a few percentage points above what Treasurys would yield. That’s in contrast to the more common “relative return’’ funds that seek to outperform benchmarks like the Standard & Poor’s 500 index.

Five years after the first fund with “absolute’’ in its name hit the market, there are now 21, and many others use absolute return strategies to some degree. Although more such funds are in the pipeline, the category’s performance is already falling short of expectations in many instances. Make no mistake, investors can lose money.

Absolute return funds will lose appeal quickly during the next bull market, predicts Rob Ivanoff, president of Financial Products Research.

Of course, the funds would look pretty good if stocks tank again. Either way, Geoff Bobroff, who runs another industry consulting firm, Bobroff Consulting, worries that absolute return funds could have a tough time executing their complex strategies if notoriously fickle individual investors rapidly cash in or out.

That rapid movement makes it more difficult for a manager to maintain a desired asset allocation within their fund portfolio. If too many investors withdraw from the fund, they have to sell off investments. This selling or buying to keep the fund’s assets in balance might not prove difficult for an experienced fund manager, but Bobroff worries that upstarts could run into trouble, particularly if the Fed begins raising interest rates.

That could force fund managers to rearrange their portfolios to meet their investment return targets, since many of the funds have large holdings in bonds and other investments sensitive to rate changes.