Absolute return mutual funds are not "risky"

We the media probably aren’t the first place you should turn for investment advice. We often rely on rules of thumb or over-simplifications. Two things bugging me today are the description of international equity funds and market neutral mutual funds here and elsewhere in articles suggesting what investors can do if they fear a market correction.

To start, the supposed diversification benefit of international funds gets a lot of air play. Here we’re talking about funds that invest in developed markets like Europe and Japan – not emerging market funds that are into China or Brazil or Slovakia. Not only is there minimal diversification generally between these sorts of funds and U.S. funds, but any such benefit vanishes when you most need it, aka during periods of market turbulence. Check out this excellent article from Financial Planning which explains how the U.S. market has become increasingly correlated with other major worldwide markets over the past decade. And here’s where the rubber meets the road: the supposed diversification all but disappears when the market tanks. For example, from the FP article, an investor who owned only the S&P 500 lost 45% from September 2000 to September 2002. Move 30% of the portfolio to developed countries outside the U.S, the MSCI index known as EAFE, and the investor’s loss was 44%. Even add in a typical 5% allocation to emerging market equities and the investor finds him or herself down 43%.

Most recently, how did the rest of the world do last week? The famed first ETF, the S&P 500 SPDR (Symbol: SPY), was down 5.5% while the iShares MSCI EAFE fund (EFA) lost 5.8%. There are good reasons to invest overseas, but diversification, especially during corrections, isn’t a very good justification. There are better ways to diversify, as I’ve tried to cover here various times, including my very first entry on this blog.

Then you have the description of the handful of market neutral mutual funds, funds like the JP Morgan Multi-cap Market Neutral Fund (OGNAX) as “risky.” Now once upon a time in times of turmoil, reporters recommended funds that only go short, like the well-known Prudent Bear Fund (BEARX). Those funds can be risky, as they stand to lose huge amounts if the markets rally. The Prudent Bear Fund, for example, has had several quarters since 2001 when it lost over 10% of value in just three months. A more statistically valid measure, standard deviation, or the average amount its returns vary month to month, comes in at about 8, according to Morningstar, versus 7.35 for the Vanguard 500 Index (VFINX), which tracks the S&P 500 Index. Worst quarter for the Vanguard 500 fund? Down over 17% in the third quarter of 2002.

But short funds have almost nothing in common with market neutral funds, which take both long and short positions. JP Morgan’s fund, for example, has a standard deviation of less than 3 and since opening in 2003 has never lost as much as 1% of its assets in a quarter. The fund trails the S&P 500’s average annual return by a wide margin over that period but it has had a much smoother ride. It beat the S&P by almost 3 percentage points over the past week. Hussman Strategic Growth (HSGFX) has a standard deviation of just under 4 and its worst quarter since 2001 was less than a 2.4% dip. It has also trailed the S&P by quite a bit over that time on average. But it returned over 14% a year in 2001 and 2002 when the broader market tanked and beat the S&P by almost 5 percentage points over the past week. How is that riskier? I’ve mentioned this before, like my post in May about the Nakoma Absolute Return Fund (NARFX), but if you give up some upside to avoid a lot of downside, you can come out way ahead.

And for free, I’ll throw in a third pet peeve which is some articles suggesting you might want to move entirely or largely out of stocks and into cash. Repeat after me: no one can time the market successfully. Well, maybe Jim Simons at Renaissance Technologies (who takes 44% of his hedge fund’s profits as a fee and still gives shareholders a return of over 30% a year – nice). But back in the real world, you’ve seen the studies. Here’s one from Prudential’s JennisonDryden unit. For the 10 years ended December 31, 2005, the S&P 500 returned about 9% a year. If you missed just the 10 best days (out of over 2,500 days the market was open) your annual return was only 4%. And if you missed just the 20 best, your return was 0.2% a year. Ouch, ouch, double ouch. Market timing – just say no.

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