With greedy investors always trying to milk the most from the stock market's biggest winners, you'd think that those with more modest expectations would have ample chances to cash in on the opportunities more ambitious investors leave behind. But at least for one set of investors looking to earn decent returns no matter what the market does, the past several years have been a solid disappointment, calling into question the entire validity of their underlying strategy.
The basics of seeking absolute return
On its face, it sounds like the perfect strategy: Buy stocks you think will go up, and sell stocks short that you think will go down. Hedge yourself with some other investments that will deliver decent returns no matter what the stock market does, and you have a combination that seems to combine the best of several legitimate investing methods into a single investment vehicle.
That's the theory behind absolute return funds. Also known as long-short funds or market-neutral funds, the absolute return strategy has a number of varieties, but it all boils down to one common goal: earn stock-like returns year in and year out, without the volatility that owning a simple stock market index fund brings you.
Unfortunately, the various absolute return strategies haven't delivered good performance in recent years. According to Morningstar data -- which breaks absolute return funds into long-short and market-neutral categories -- funds following absolute return strategies have lost money on average over the past three years. Moreover, long-short funds lagged the market dramatically in 2010, producing less than 6% returns versus the S&P 500's double-digit returns. Market-neutral funds actually dropped in value in 2010, as well. What's going on?
Looking behind the numbers
For an example of what can go wrong, let's take a closer look at the Hussman Strategic Growth Fund (HSGFX). I bought shares of this fund a couple of years ago as a hedge against a potential double-dip. But a combination of factors conspired to create subpar returns.
On one hand, many of the fund's long stock picks have severely lagged behind during the market's rally. A big allocation to health-care stocks didn't do the fund any favors, with Merck (NYSE: MRK), WellPoint (NYSE: WLP), and Johnson & Johnson (NYSE: JNJ) all losing value in the past year as a combination of aging drug pipelines, uncertainty about health-care reform, and product recalls ravaged the industry.
In other cases, the fund's industry bet proved less of a problem than the particular stocks it picked. Technology has produced some great returns over the past year, but Hussman's pick of Microsoft (Nasdaq: MSFT) has underperformed many of its rivals, as the company struggles for future vision. Similarly, Colgate-Palmolive (NYSE: CL) has lost 1% of its value in the past year, even as rivals like Kimberly Clark earned double-digit returns.
Finally, the fund's short strategy has been pretty much a complete failure. The Hussman fund uses index put options to hedge against market declines. Since stocks have rebounded upward, the money the fund has spent on options has evaporated, dragging down returns.
Failing to deliver
In order to succeed, most absolute return funds have to do several things right. If they make great long picks but get their short sales wrong, or vice versa, then their performance will suffer.
Another problem may have come from the nature of 2009's rebound. In the aftermath of the market meltdown, the riskiest stocks looked like obvious short candidates. But the companies with the highest risk of bankruptcy, including Freeport-McMoRan Copper & Gold (NYSE: FCX) and Caterpillar (NYSE: CAT), ultimately produced some of the highest returns during the recovery rally. Meanwhile, more prudent picks lagged behind.
Of course, not every fund has been a failure. Robeco Long-Short (BPLEX) has gained more than 24% annually since early 2008, with a small-cap investment style that has reaped rewards from stellar performance of stocks like Lithia Motors and Rackspace.
Hold onto your risk
In general, though, the overall difficulty that long-short funds as a category have had supports the idea that if actively managed mutual funds are already at a disadvantage, actively managed funds that have to make several different market calls are at an even bigger disadvantage. Even if the strategy is a reasonable one, the funds' failure to put it into practice makes it clear that you should look elsewhere for safe, consistent investments.
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