Should I buy an absolute return mutual fund?

Posted by on May 26, 2010 in Investment Information

A traditional mutual fund works on what is known as a relative return basis; its return is relative to some benchmark or its industry peers.  The result is that a mutual fund could have acceptable relative performance but a poor absolute performance. For example, if the S & P 500 falls 5% in a year but a broad based American mutual fund returns 2%, it is considered a success on relative terms.

In the never ending search for return (regardless of the risk), the mutual fund industry has marketed absolute return mutual funds heavily in the last 12-18 months (the unspoken reason is that many investors have discovered that the principal protected note, which was sold to the same group of investors seeking stable returns, is a dud investment product). Absolute return, as the name implies, means the product will make a gain no matter what the market conditions. An absolute return mutual fund attempts to deliver positive returns by employing unconventional active management strategies to the mutual fund industry (shorting, arbitrage, currency trading to name a few).

Is the absolute return mutual fund for you?

The one thing that jumps out at an investor is its fees. Forbes found that an average absolute mutual fund charged 1.8% in assets in fees and overhead which is above the American average of 1.3% charged by all actively managed equity funds. As usual, pump up the fees about 1% and you have your Canadian equivalent. For example, the BMO Guardian Global Asset Return (Advisor Series) charges a MER of 2.47%.

Cost in the abstract are neither good or bad thing. What really matters is whether you are deriving value for the cost paid. In this respect (setting aside the question of whether the advisor is providing good advice for fees charged), the absolute return mutual fund is not a value play. Of 106 absolute return mutual funds studied over a 5 year period, the average annual return was 2.6% compared to 2.8% of the S & P 500. In other words, a do it yourself solution of buying an ETF which tracks the S & P 500 would have outperformed this product.

Similarly, Morningstar found that in 2008, only 1 of 8 absolute return fund studied provided a positive return of 1.1% while using a traditional hedge against equities, such as t-bills, would have provided better protection against a terrible market for equities.

Absolute return mutual funds can be seen as the child of hedge funds and principal protected notes: two products with mixed histories with the only consistency being the issuers made a pile of money. Knowing the average investor has short memories and a lack of analytical rigor, the financial industry push the product anyways understanding most will not piece together that the absolute return mutual fund is a love child of two unfit parents. I don’t blame the industry on continuing to prey on an uninformed public. Just don’t be that prey.

The alternatives to absolute return mutual funds are elegantly simplistic. If you like mutual funds, find a balance mutual fund with a low MER and make sure that it is properly balanced between equities and fixed income (look at its holdings in the summary disclosures given to you). Most I looked at had a slight overweight towards equities (approximately 60% equity/40% fixed income). If this is too much exposure in equities, balance this off with a fixed income product (preferably an ETF- although this is subject to some debate)

Alternatively, purchase ETFs which track a broad based index (emphasis on broad) and allocate holdings between equity and fixed income to hedge against volatility. For those who are conservative, take 100 minus age as equity allocation. For those who are more conservative, lop another 10%-15% off the previous number. For investment return based on asset allocation, I would refer to this post on equities risk and reward.

Finally, there are a few simple steps to take control of your portfolio which Michael James set out.

Good luck.

3 Comments on Should I buy an absolute return mutual fund?

By Dale Rathgeber on May 26, 2010 at 12:42 pm

I absolutely agree that most of these “absolute return” products are high priced junk, and that “costs in the abstract” are neither good, nor bad. But I strongly disagree that balanced mutual funds should play a part in any portfolio; they have too high an MER for the bond component of a portfolio. A better solution is a few bond ETFs, after interest rates bounce off of their lowest in a generation lows. These are a less expensive compliment to equity ETFs or Mutual funds. (In some cases a High MER can be justified in an out-performing equity mutual fund; almost never in a bond fund).

By Richard on May 26, 2010 at 3:21 pm

Much like PPNs, an absolute return fund might sound good but I think the challenges to actually making it a good investment are too great for me to to the research needed to invest in one. An absolute return manager is claiming that they can avoid most risk and, if you use the general stock market in the last couple of years as a benchmark, outperform by 30-50%! Any investment manager making those claims is one that should only be approached by very experienced investors.

Of course, a more valid comparison might be government bonds since those pretty much always have an “absolute” return if they’re short enough. In that case maybe the absolute return manager only needs to outperform by 1-2% without adding significant risk. That’s slightly more doable, but if you’re looking for better fixed income instruments would you avoid ABCP?

By » Round-up of financial blogs Canadian Business Blogs | Advice on Investment in Canada, Stock Market, Small Businesses Opportunities on June 7, 2010 at 12:11 am

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