Swedroe: The Absolute-Return Rip-Off

January 30, 2014

How bad are absolute-return funds? Larry Swedroe counts the ways.

Investors would love to be able to achieve positive returns in both bull and bear markets, and that’s the “promise”—or at least the premise—of absolute-return funds.

The devastating bear market of 2008 increased the demand for these funds. Wall Street is happy to meet that demand with its usual array of high-cost vehicles. In 2000, absolute-return funds had $2 billion in assets under management.

By the end of 2010, that figure had grown to $25 billion. Thus, it’s clear that investors believe—or are conned into believing—that absolute-return funds are likely to achieve their objectives.

Absolute-return funds try to accomplish their objective using a wide variety of strategies. While some absolute-return funds invest primarily in stocks and bonds, others use commodities, short selling, futures, options and other derivatives, arbitrage strategies, currencies, credit risk, leverage and almost anything else you can dream up.

That’s one of the many problems with these funds—you just don’t know what they own and what risks you’re exposed to. The question for investors is this: Despite these issues, are absolute-return funds likely to achieve their objectives? The authors of the study “Do Absolute-Return Mutual Funds Have Absolute Returns?” published in the winter 2013 issue of The Journal of Investing, sought the answer to that question. The following is a summary of their findings:

  • Absolute-return funds have much higher fees (about 0.5 percent higher) and turnover (about three times greater) than ordinary stock funds.
  • They don’t create positive alpha for investors, even at the gross, before fees, level. Using the Fama-French four-factor (beta, size, value, and momentum) model, the average monthly alpha was -0.11 percent—slightly worse than the average stock mutual fund’s monthly alpha of -0.07 percent.
  • Larger absolute-returns funds, the ones with the most assets, perform worse than smaller ones.
  • They do exhibit about half the volatility of stock funds.
  • They can have significant exposures to factors—such as beta, credit risk, momentum and emerging markets—that determine returns, factors that can be accessed at much lower costs using passively managed funds, such as index funds.

The authors concluded: “Investors seeking absolute returns using mutual funds are likely to be disappointed.” In other words, via the high fees charged, the sponsor’s objectives were met. It’s just that the objectives of investors weren’t.

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