Invest Wisdom

Last week, a Wall Street Journal columnist wondered if managed futures were really a healthy contribution to a diversified portfolio.

This week, absolute return mutual funds are under the microscope.

Absolute return funds are mutual funds in which the mutual fund manager can invest in or sell short nearly anything he wants. If he thinks U.S. stocks are primed for an upswing, he can buy U.S. stocks. If he thinks the Euro will surge against the U.S. dollar, he can invest in Euros.

That’s a big difference from the relatively tight boxes that normal mutual funds are stuck into. Most of the time, managers are limited to picking the best companies within, say, the U.S. mid-cap growth category. Because absolute return managers can bet against the market just as easily as they can bet with it, they’re supposed to make money whether the market is rising or falling.

Some mutual fund companies think that absolute return funds are the next big thing in their industry. I know of at least five that have launched over the last couple years and have spoken to a couple mutual fund managers who plan to launch them.

It’s a concept similar to one I discussed last month, and comes down to the same, fundamental question: Who should determine your asset allocation: You or an expert?

The Wall Street Journal columnist comes down somewhere in the middle, writing “The right absolute return fund can make a great addition to a balanced portfolio.” Despite that statement almost being a tautology (Just avoid the “wrong” absolute return funds, and you’ll be fine), I’m not sure I agree with the writer on what their role should be.

To me, “diversification” means diversification between assets. So even when one asset does poorly, another one can pick up the slack or at least do less poorly.

Investing in an absolute return fund, on the other hand, diversifies your investment styles. If you put 10% of your money in a total return fund and invest the rest yourself in your usual mix of index funds, your portfolio really now has two money managers setting your asset allocation: You, and the guy you gave 10% to.

There’s nothing inherent in the absolute return fund that should make it “zig” when others “zag” as the WSJ headline asserts. The manager could very well pick the exact same allocation that you had chosen. Instead, it seems like you’re completely at the mercy of how good the manager is at his job. Since so few of these funds have any sort of track record, I don’t think I’d be the first one to hop on the bandwagon.

— Joe Light