Absolute-Return Funds Are Down, Not Out

Absolute-return funds have lagged their peers during the rally, but now is not the time to sell them.
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NEW YORK (TheStreet) -- It's time to revisit absolute-return funds now that the bear market seems to be over.

Two and a half years ago, I wrote about the

Rydex Managed Futures Fund

(RYMFX) - Get Report

, which was new. At the time, the financial sector was starting to show signs of trouble with the failure of a couple small mortgage lenders. The basic premise behind absolute return was that it could shield investors from big declines.

Absolute-return and many alternative-strategy products try to deliver a consistent return regardless of the market environment. Not every fund in the space will achieve that, but some can. Since that article, I have profiled the

Nakoma Absolute Return Fund

(NARFX)

and the

Dover Long Short Sector Fund

(DLSAX)

. The Rydex fund goes long or short commodity futures and financial futures based on seven-month relative strength, and the Nakoma and Dover funds are actively managed, choosing what to go long or short.

All three funds performed as advertised until the low in March. During the worst of the bear market, interest in these funds, based on media reports and anecdotal comments on my blog, went off the charts, which makes sense because these funds were "working."

Just as everything went down a lot during the bear market, except some absolute funds and Treasuries, we have seen everything go up a lot in what is now a five-month rally -- everything except some absolute-return funds and Treasuries. During that five-month rally, the S&P 500 is up close to 50%, and all three funds are down 5% to 10%.

So is now the time to sell this type of fund? If you ever bought an absolute-return fund, why did you buy it? What role was it intended to play in the context of a diversified portfolio? Managing volatility is its biggest role because absolute-return funds are much less volatile than the stock market. Despite the small decline in the past few months, that is exactly what the funds continue to do.

Additionally, when is the stock market more likely to fall, after a 40% decline that terrifies people or after a 50% rally that wipes away the fear and replaces it with excitement? That's not intended to be a prediction as opposed to recognition of what point in the cycle carries more risk. The way the stock market tends to work, the risk of going down a lot is less after it has already gone down a lot. The market tends to be more vulnerable during periods of excitement or complacency. This is an idea that John Hussman, manager of the

Hussman Strategic Growth Fund

(HSGFX) - Get Report

, another fund that navigates successfully in this space, has been writing about for years.

Even the drag created during the rally by a 10% allocation to absolute funds, which is about double what I have for clients, can be overcome with proper diversification that includes emerging markets, which are up 80% during the rally, and foreign developed stocks, up 60%.

There will come a point when the stock market goes down again and gives a lot of people a good scare. That may happen now or not until the next bear market, but it will happen and when it does, successful absolute-return vehicles will again stand out and become popular. It might make sense to hold on to a small allocation in this type of fund in case you aren't certain when the next big downturn will come.

At the time of publication, NARFX, DLSAX and RYMFX were client or personal holdings.

Roger Nusbaum is a portfolio manager with Your Source Financial of Phoenix, and the author of Random Roger's Big Picture Blog. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Nusbaum appreciates your feedback;

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