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Absolute return strategies work best for advisors who are concerned with capital preservation and risk reduction, and not with those whose goals are “hitting the home run.”  The beauty of the strategy is its accessibility to all investors.  It will resonate particularly well with high- and ultra-high net worth clients who want to emulate some of the tactics used by endowments.

Advisors evaluating absolute return funds need to use a range of metrics in their analysis.  Peer group comparisons may not relevant, and comparing performance to traditional benchmarks (such as the S&P 500) obscures the value these funds offer.

Morningstar assigns absolute return funds to a variety of categories, including Long-Short, World Allocation, and Conservative Allocation, which can make identifying these funds difficult.  The Long-Short category, created by Morningstar two years ago, includes funds pursuing specific strategies (such as merger arbitrage) and others taking an extremely defensive position (i.e., market-neutral funds).  Given the range of funds and the diversity of strategies within the Long-Short category, advisors should use peer group comparisons with caution.

Dan Traub, an advisor with Braver Wealth Management in Newton, MA, uses absolute funds for their risk reduction value, and not directly as a proxy for fixed income.  “The most important thing we look at is performance in both up and down markets.   In a market like today, we expect flat or slightly negative results.  But we don’t expect these funds to be up as much in a strong bull market.  When the market is up 30%, a 10% return is okay.”

Advisors should consider the beta relative to both equity and fixed income markets.  Some funds, such as the Gateway Fund (GATEX), will have a higher beta to the S&P 500.  Other funds, such as Absolute Strategies (ASFIX), specifically target a low beta relative to the S&P 500.  Especially for funds with low beta to the S&P, advisors should utilize the Sharpe Ratio, which measures the fund’s return per unit of risk, independent of its covariance to any index.

A low correlation is essential in reducing volatility.  Fund Grades offers a convenient feature to simultaneously view fund correlations to a variety of indices.   Correlations are dynamic and, for many investments, have the undesirable quality of converging to one in a down market.  It is precisely this phenomenon which creates the opportunity for some funds with low correlation to add diversification value. 

Expect to pay higher fees for this class of funds.  By design, these funds are delivering low beta and high alpha.  Expense ratios for these funds should be viewed relative to their alpha exposure.  The cost of beta is almost free, since it can be purchased through a low cost index fund or ETF.  For a comprehensive discussion of assessing fees for active management, see the paper by Ross Miller on this subject.

The most important element of fund evaluation is a careful assessment of the fund’s strategy.  Traub looks for “consistency in the performance, methodology, and process used by the fund. “

For a fund of funds, it must be run with a consistent overall strategy, and must carefully select funds and sub-advisors that contribute to this strategy.  Advisors will want to understand the fund’s composition and selection process for sub-advisors and, in particular, look at the following:

• Size of fund – Larger funds will have access to more sub-advisors and to those that are more skillful.
• Liquidity – Do the sub-advisors invest in illiquid securities and, if so, with what criteria, constraints, and risk controls?
• Diversification of sub-advisors – Advisors will want to assess the level of diversification across sub-advisors in the fund, whether sub-advisors are style-box agnostic, and the degree of independence and flexibility they have in pursuing their investment strategy. 
• Complexity of strategy – How complex is the strategy of the fund and of the sub-advisors?  Simplicity, and fewer moving parts, is preferable when the goal is risk-reduction.

An open end mutual fund may use hedge fund managers and hedging strategies, but will not invest directly in hedge funds.  Funds are custodied by the fund manager, and trading is done through separately managed accounts (SMAs), with the sub-advisors providing trading instructions.  The fund is priced by the fund administrator, not by the sub-advisors.

The final decision is the amount of the portfolio to dedicate to alternative strategies.  Hlidek suggests allocating 10-20% of your portfolio.  He says, “Go ahead and manage the rest actively or passively, with funds or ETFs.  The real challenge of the next five to ten years will be finding diversification.” 

Compson’s goal is to at least meet the returns of a traditional 60/40 portfolio over the long term, but to get there without the same level of volatility.  He believes the combination of volatility and a bear market create a great environment to assess skill.  As Warren Buffett famously noted, “when the tide goes out we see who is wearing a bathing suit.”

Sample Funds

Below are some funds that offer absolute return or similar strategies.  This is not a complete list of all such funds.  We have chosen to show total return data for the period from June 30, 2007 to February 29, 2008, because this period encompasses significant volatility and the current bear market.

Many of these funds have significant holdings among HNW and UHNW investors, whose assets are managed by RIAs, in the Advisor Perspectives universe.  We show the ranking of the funds among the Most Popular Mutual Funds in our universe, as of February 29, 2008.  A value of n/a indicates no significant holdings in the universe.

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