Can Absolute Return Funds Hit Their Targets?

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NEW YORK (TheStreet) -- Absolute return funds aim to deliver competitive results in good times and bad. But many of the funds suffered painful declines in 2011, a year when the S&P 500 gained 2.1%. Among the losers was American Independence Absolute Return Bull Bear Bond AABBX , which dropped 9.3%, according to Morningstar. Funds that lost more than 3% included Absolute Opportunities AOFOX and Quaker Akros Absolute Return AARFX .

Should you stay away from the funds because of one bad year? Some analysts think so. They argue that absolute return funds are only worthwhile if the managers can deliver consistently positive results. But portfolio managers counter that 2011 was an unusual year when volatile markets whipsawed all kinds of strategies. The managers say that they can produce competitive results over a market cycle of three to five years.

Plenty of investors have been siding with the fund managers. Although most absolute return funds have been operating for less than two years, the group already has $11 billion in assets. For shareholders, the funds appear to be vehicles that can cope with difficult markets.

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Absolute return investments follow a variety of strategies, but they are all fundamentally different from conventional mutual funds. Conventional funds aim to outdo a benchmark such as the S&P 500. Managers consider themselves successful if they lose less than the benchmark in downturns. In contrast, absolute return funds claim that they avoid tracking benchmarks. The funds can sell short or use other techniques so that shareholders don't necessarily lose money when markets sink.

Critics say that investors do not understand the risks of absolute return funds. Because the funds aim to achieve absolute returns, investors figure that they will never lose money. In fact, many funds are almost guaranteed to decline in downturns. This is true because the portfolios do only a little shorting and hold big stakes in stocks or bonds. When markets sink, so will the funds. To be sure, the absolute return funds may lose less than the market -- but they will still fall into the red.

"If a fund moves in the same direction as the market, then you should not call it an absolute return investment," says Terry Tian, a Morningstar analyst.

Some analysts have gone so far as to argue that regulators should bar most funds from calling themselves absolute-return vehicles. Fund companies argue the absolute return funds are not misleading investors. In their disclosure documents, the funds clearly state they may sometimes lose money in downturns. The absolute return funds are worthy of the name because they do not always track the benchmarks. The fund companies contend that the SEC permits some latitude in naming funds. For example, funds can label themselves as growth portfolios -- even if the performance does not always justify the name.

Cases in Perspective

To appreciate the debate over the funds, consider Putnam Absolute Return 300 PTRNX . The Putnam fund seeks to outdo Treasury bills by 300 basis points (3 percentage points) annually over a market cycle. During the past three years, the fund returned 3.1% annually. But in 2011, Putnam lost 4.4%. Seeing the data, portfolio managers argue that the Putnam fund is on track to meet its long-term target. Critics contend that the fund offers uncertain protection.

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Can the absolute return funds deliver competitive long-term returns? Because the funds are so young, it is too soon to draw any firm conclusions about their performance. Still, many of the funds are intriguing because they have unusual flexibility to cope with difficult markets. Among the more flexible bond choices is Loomis Sayles Absolute Strategies LABAX . The fund has the ability to short bonds. That could be particularly important in coming years.

Loomis Sayles managers say that for the past three decades, bonds have been in a bull market. Now many economists expect that interest rates will rise in the next decade. If that happens, bond prices will fall, and conventional bond funds could face hard going. In such a difficult environment, absolute return bond funds could race to the front of the pack.

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An unusual stock fund is WBI Absolute Return Dividend Growth WBIDX . To limit losses, the fund sells stocks after they have fallen by 10%. If the market craters, the fund can dump its stocks and shift to cash. The system is designed to protect shareholders from the kind of big losses that occurred in 2008.

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