A growing emphasis on absolute-return strategies is leaving some analysts advising caution, even though the returns often look good on paper.
In the wake of a stock market that has humbled relative return strategies, there is concern that a rush to jump on the absolute-return bandwagon could lead to an overabundance of new products and a flood of hot money into existing products.
“Right now, there are a lot of red flags to consider, but if they can be overcome, absolute-return strategies could redefine the fund industry,” said Don Phillips, managing director with Morningstar Inc. in Chicago.
Although he likes the idea of an increased emphasis on more predictable returns, he is concerned that some strategies might not live up to expectations and that investors will pour in at the wrong time.
“There is an element of absolute-return strategies that looks like some of the gimmicks the fund industry has seen before,” Mr. Phillips said. “They are highly engineered products that try to reshape the pure stream of returns that the market gives you.”
Even though a few dozen funds already claim absolute-return objectives, Morningstar has no category for the strategy.
Lipper Inc. of New York, which also doesn't pull out such funds in a separate category, counted 30 funds that would fit in that category but are lumped in with market-neutral, long/ short equity and global income, among other categories.
“This is a strategy that amounts to putting all of the allocation decisions in the hands of a manager,” said Jeff Tjornehoj, senior research analyst at Lipper.
“Ideally, you want a manager who would have moved all the money into Treasuries in October 2007 when the market peaked, but you don't always get that.”
The most recent example of the trend toward absolute-return strategies was the January launch of four such funds by Putnam Investments in Boston. The funds, which have already attracted $200 million, are designed to provide returns above those of Treasury bills by 1%, 3%, 5% and 7%, depending on the fund.
“Absolute return is going to be huge for all the obvious reasons, including that it allows advisers to dial in the type of returns they want for their clients,” said Robert Reynolds, Putnam's president and chief executive.
There is nothing like a historic stock market implosion to test in-vestor loyalty to relative-return strategies, which are designed to outperform a particular index.
Independence from the di-rection of the overall market is among the strongest selling points of absolute return.
“After 2008, financial advisers and investors are looking for sources of return that are less de-pendent on the market's movements,” said Rick Lake, co-chairman of Lake Partners Inc.
The Greenwich, Conn.-based firm has $4 billion under advisement and manages another $250 million, mostly in a separately managed account strategy that invests in hedged mutual funds to generate an ab-solute return.
In April, Lake Partners packaged the strategy into a mutual fund, Aston/Lake Partners LASSO Alternatives Fund (ALSOX).
“Investors and advisers will need to climb the learning curve,” Mr. Lake said. “But after last year, I'm sure people are looking for positive returns no matter what happens.”
That learning curve will be crucial to managing expectations among both advisers and investors, according to Lee Schultheis, founder and chief investment officer of Alternative Investment Partners LLC, a West Harrison, N.Y.-based firm with $285 million under management.
“People will have to understand absolute return doesn't mean it will always go up, because other than T-bills, nothing will always go up,” he said. “After last year, absolute return might be a label people ascribe more latitude toward, and they will have narrower bands of expectations.”
The inability to manage expectations nearly wiped out absolute-return funds in Europe, where more than 1,000 funds attracted $130 billion in 2005 and 2006.
However, according to Strategic Insight Mutual Fund Research and Consulting Group LLC in New York, misleading promises, poor expectation management and disappointing performance resulted in nearly $100 billion in net redemptions and several liquidations in 2007 and 2008.
“Absolute-return notions of reducing volatility and limiting negative-return periods are enormously and universally appealing yet ex-traordinarily difficult to construct and deliver,” said Loren Fox, Strategic Insight senior research analyst.
The case for absolute return is an easy one to make, which helps ex-plain why more than 2,000 brokers have already sold one of the new Putnam funds and how the funds have been set up as the default strategy in seven defined contribution plans.
“Our goal is to hit a targeted return, not to chase an index,” Mr. Reynolds said.
Of course, he acknowledged, “if the stock market is really booming, you'll be 7% over Treasuries.”
This gets back to the delicate balance of expectations, according to Mr. Phillips, who underscores the fact that a rising market generally favors relative return strategies that track a market index.
“It's the kind of fund the investor will probably buy and sell at the wrong time,” he said. “Nobody would have touched an absolute-return strategy at the end of 1999 [at the peak of the technology bubble], and you have to wonder about signing up for a 3% return when the market is now at a decade-long low.”
However, Mr. Phillips added, in this economy, there is something to be said for a smoother and more predictable investment strategy.
“The mutual fund industry has always focused on relative returns in a world where investors are facing real-world challenges,” he said. “Spending needs are more predictable than the market's flow of returns, and these funds focus more on that outcome.”
E-mail Jeff Benjamin at email@example.com.