Why “Absolute Return” Funds Absolutely Underperform

Billions of dollars tumbled into absolute return funds in the wake of the financial downturn.  Although these funds may guarantee absolute returns, they’re more likely to under-perform.

The Basis of the Business

Unlike other mutual funds and even exchange-traded funds, an absolute return fund has more in common with insurance policies than it does investments.  The goal of the funds is to protect investor’s wealth while generating returns equal to the stock market in the good years.  The unfortunate reality is that these funds always under-perform solely due to their limited risk exposure.

Take a Look Under the Hood

Shopping for a good mutual fund is akin to purchasing a used car.  You must look for a solid frame and hope the innards are reliable enough to perform for the price you pay.

However, when you open up an absolute return fund, you may be shocked how they invest.  Often, these funds are invested largely in annuities, corporate bonds and treasuries, which help maintain their value, while just a few percentage points of the fund have any exposure to risk.  Frequently, half or more of the fund will earn 5% in debt obligations, while the rest yields results equal to the stock market.  Assuming a 60/40 mix of bonds and stocks, the aforementioned portfolio would yield about 7% when the stock market is up 10%.  This is not a bad return, but absolute return funds are often the most expensive investments, costing as much as 2% per year.  Take that fee right off the top for earnings of 5%.  A corporate bond portfolio can beat that return!

Make Your Own Absolute Return Fund

With some basic math and an options account, virtually every investor can make his or her own absolute return fund that will actually perform as it should, without all the fees and expenses.

The first step in creating your own absolute return fund is to invest your portfolio, minus what you expect to earn per year in fixed income into a bond fund.  In this case, corporate bond yields are about 5% per year, and thus, you would invest 95% of your capital into said bond fund.  Your next step is to take the other 5% and invest it directly in stock options for your favorite indexing ETF.  Many people prefer to use the SP500 SPDR (SPY).

Picking the Right Option

Ideally, you’ll want to buy an option contract that is well in the money and at least one year from the start date.  In this case, September 2010 contracts work perfectly.  The stock currently trades at $107, and call options with a strike price of $100 are currently selling for $14, a 7% premium over true value.  Normally, spreads are much lower; however, recently volatile markets have made option premiums more expensive.  (The VIX index, which is calculated solely on option premiums, is currently at 23, which is normal for 2008, but much higher than the 10 point level set in 2007).

Let’s Do the Math

Let’s see how this model portfolio would respond if the stock market dipped 10%, stayed flat, or rose by 20%.

If the stock market fell by 10%, our options would be worth nothing, while our bonds would perform by 5% per year to keep us at breakeven.

Should the stock market stay flat, our bonds would earn 5%, while our options would have lost half their value (due to the premium).   In this case, we would earn 5% from the bonds and an adjusted -2.5% from the bonds for a total return of 2.5%.  (We beat the stock market here.)

Should the stock market rise by 20%, our bonds would yield 5%, while the options would have doubled.  The net result would have been a 10% return.

The Math Doesn’t Lie

Absolute return portfolios are well ahead of the market in the bad times, but far behind the market in the good times.  For someone seeking to grow wealth rather than merely keep up with inflation, absolute return funds simply aren’t ideal.  They’re too slow to grow and only serve a practical purpose when trying to squeeze the most out of a fixed income portfolio.  If you do opt for an absolute return strategy, make your own portfolio of stocks and bonds, saving yourself the hefty fees and producing nearly the same results.

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