Investors’ attraction to absolute-return mutual funds has not been justified by their performance. Fund assets grew from $2 billion in 2000 to $25 billion in 2010, but there is no evidence of positive alpha, market risk is not eliminated, and fees and turnover are high. The only positive is that absolute-return mutual funds are less volatile than traditional mutual funds.
What’s Inside?
The prevailing view is that the vast majority of actively managed mutual funds underperform their passive benchmarks, whereas some evidence exists that hedge funds generate positive alpha. The authors analyze the holdings of absolute-return funds to determine whether they are consistent with their stated objectives and whether they show higher relative performance in comparison with typical mutual funds and hedge funds. They find that although absolute-return funds reduce market correlation and have lower variance in returns, they fail to meet their other objectives. The authors also demonstrate that absolute-return funds underperform related market-neutral hedge funds.
How Is This Research Useful to Practitioners?
The objective of an absolute-return fund is to produce positive, low-volatility returns independent of market influences and conventional benchmarks. It is the separation of systematic and idiosyncratic risk combined with the goal of stable returns that makes absolute-return funds unique. Absolute-return funds seek to achieve low-volatility and consistent returns that are uncorrelated with the market. To accomplish this goal, these funds typically use a wider variety of asset classes than just equities and bonds.
The authors compute average characteristics for stock and nonstock absolute-return funds and compare them with equity mutual funds using two different models. They find that although smaller in size than equity mutual funds, absolute-return funds have a number of differences; for example, absolute-return funds attract higher inflows of capital and have higher expenses and turnover. In addition, compared with other funds, their mean net returns are approximately half, they are half as volatile, and their correlation with the S&P 500 Index is approximately half. Regardless of the model used, the average absolute-return fund did not generate positive alpha. A comparison of stock and nonstock absolute-return funds produces generally similar economic results. Asset allocation analysis reveals that stock absolute-return funds have significant stock holdings (95% on average). Nonstock absolute-return funds, however, prominently feature cash (51% on average) and a greater use of alternative investments.
Although the average absolute-return fund does not generate positive alpha, some individual absolute-return funds do. The authors use three different models to test equally and asset-weighted portfolios to check for alpha in individual funds. For all models and weightings, they find positive alpha only once, representing 0.02% per month. Significant market exposures remain, often outside traditional US equity markets. When they control for higher absolute-return fund fees, it does not have a significant impact on the results.
Because of the similar mandates, the authors compare the performance of absolute-return funds with market-neutral hedge funds. They find that market-neutral hedge funds outperform absolute-return funds even after controlling for the upward bias from self-reporting found in hedge funds. In aggregate, absolute-return funds have greater exposure to equity risk, whereas hedge funds have higher exposure to bond credit spreads and stock momentum strategies.
How Did the Authors Conduct This Research?
The sample of absolute-return funds covers the period of 2000–2010, which coincides with their enormous growth. The sample is created using the CRSP Survivorship-Bias-Free US Mutual Fund Database and is based on Lipper Objective Codes, fund prospectuses, and the fund names themselves. Because absolute-return funds are relatively new, not all funds are classified correctly. Many market-neutral and long–short equity funds have been labeled as “absolute-return funds,” and although they are similar, the equity market exposure of absolute-return funds is substantially less than that of market-neutral funds.
The authors initially identify 56 unique absolute-return funds with a total of 2,973 monthly observations. The sample is further divided into “stock” funds and “nonstock” funds. Stock funds are those with a minimum allocation to stocks of 70%. The nonstock funds contain a wider range of asset classes, including commodities and mortgage-backed securities, but they are smaller in size than stock funds. Early in the period, stock funds are more prevalent, but from 2007 onward, the number of nonstock funds has been increasing. Although the trend of nonstock funds is increasing, as of 2010, stock funds accounted for 42% of the assets under management of absolute-return mutual funds. The final sample contains 1,529 fund-month observations for stock absolute-return funds and 1,171 fund-month observations for nonstock absolute-return funds.
Abstractor’s Viewpoint
Given the finding that many investors continue to pour money into underperforming absolute-return funds, a useful follow-up study would examine the reasons for this apparent irrational behavior. I also think it would be useful to know whether any absolute-return funds generated alpha compared with their stated benchmarks as opposed to the factor models the authors used. The reality is that most investors who assess alpha do so using the stated absolute-return fund benchmark and not using sophisticated factor models. Finally, I would be interested to know whether the classification challenges experienced early in the sample period biased any of the results.