Analyzing Absolute Return OEFs

In my readings I stumbled across an absolute return OEF which sent me looking for others in the category that I hadn't previously heard of. I just wanted to take a look under the respective hoods to see if there were any themes that carried over or any other trends to learn from.

It seems there can be many different flavors of absolute strategies. As I looked at the holdings of a few of them I only noticed a couple of recurring things.

The first was liberal use of ETFs presumably just to capture pure exposure of broad markets or big sectors. It is interesting to see ETFs show up in mutual funds.

Some might squawk about a fund owning a fund. However, one common strategy is pairs trading and using an ETF for at least one side of the pair can reduce risk. Instead of shorting Citigroup (C) and having to pay out almost 6% in dividends, might it make more sense to use ProShares Ultra Short Financials (SKF)? After all C and iShares Financial (IYF), which is what SKF is double shorting, have an 0.89 correlation. So, instead of paying out Citi's dividend you can collect SKFs t-bill interest.

Some fund managers would find that line of thought compelling, which is why ETFs show up in some funds but others obviously will not think ETFs make sense.

Another thing that showed up was high, think 40-50%, cash balances. Keep in mind that the reported holdings were old and these funds may not have high cash now. A lot of cash is valid but with cash rates so low it means the rest of the portfolio needs to work harder if the goal of the fund is something like CPI plus X%.

If Ken Heebner opened an absolute return fund and said he was going to put 90% in T-bills and split the remaining 10% between two stocks he said would go up at least 100% in the next 12 months. The implied return would be something close to 12% and I think people would line up around the block. While that example is ludicrous, a lot of cash does not have to be bad depending on the overall strategy.

If you have interest in the effect created in this space you probably need to explore the various approaches that exist, or as many as you can find anyway. Then find the best intellectual and emotional fit. If a manager likes 30% cash balances and you don't, it's probably a bad fit for you.

It also seems like most of the funds in this space are expensive, in the vicinity of 2%. Given the differentiation in the space, I think shopping for a cheap one might be very difficult. Maybe I'm wrong, but with absolute return funds I think you really are betting on the brains of the manager. This, as opposed to something like an actively managed large cap value fund. If LCV is doing very well it is likely that your LCV fund is going to do well too, but if LCV does poorly your fund would also do poorly and it would be deemed acceptable.

But a fund manager who uses some sort of arbitrage to deliver absolute needs to deliver the same return with his strategy in all market conditions. If he can actually do that, he might be worth 2%. Obviously if 2%, or something close to it, is too much for you then you shouldn't buy the fund.

Comments

[dumbo]

[Please don't use uncommon abbreviations w/o explaining them.] What's an OEF?

[dcamp6504]

I assume he means Open End Fund, as opposed to a CEF or Closed End Fund; but it would nice to have an example.....

[Roger Nusbaum]

OEF=open end fund