Financial engineers for decades have sought to develop absolute-return investments, funds that make money every year, even during bear markets. Bernie Madoff understood the appeal of such reliable vehicles and gave investors what they craved. Honest money managers have failed in their quest to deliver perfect absolute-return funds. But with investors desperate to avoid losses, fund companies are offering a wide range of absolute-return vehicles. One of the most ambitious efforts is a family of four funds introduced recently by Putnam Investments. The funds range from cautious to aggressive. At the tame end of the spectrum is Putnam Absolute Return 100 Fund ( PARTX), which seeks to outdo Treasury bills by 100 basis points annually, or 1 percentage point. Other Putnam funds aim to beat Treasuries by margins ranging from 3 to 7 percentage points. Can the funds hit their targets? The odds for success this year are high. At a time when 3-month T bills yield 0.20%, the Putnam funds needn't take much risk to achieve their goals, and the portfolio managers are playing it safe. Putnam Absolute 100 has most of its assets in short-term investment-grade corporate securities. Putnam Absolute 300 ( PTRNX) also has short-term holdings that should meet the target, even if the markets remain difficult. The 500 and 700 funds take on only slightly more risk, owning some longer-term bonds. Those could sink in a bear market. Putnam managers concede that their funds may not generate positive results every year. But they aim to hit their targets over market cycles of three to five years. Achieving the goal will become more difficult once Treasury yields rise back to normal levels. To hit the target, the funds will need to own more aggressive choices, including stocks, commodities and real estate investment trusts (REITs). No matter what the portfolio holds, the goal will always be the same: to reach the return targets while taking as little risk as possible.
Like Putnam's portfolios, many absolute-return funds rely heavily on fixed income. But other absolute funds use a variety of techniques, including selling short and buying stocks involved in mergers. These strategies can produce solid returns during bear markets. Whichever method they prefer, investors should keep in mind that the absolute-return funds are designed to deliver consistency, not huge returns. During bull markets, strong funds typically eked out modest single-digit results. In difficult years, many managers have dipped into the red. To appreciate the reality of what absolute-return funds can deliver, consider JPMorgan Market Neutral ( JPMNX), a top choice. Like many competitors, the fund aims to limit losses in downturns by short selling. As a market-neutral fund, JPMorgan buys attractively priced stocks. Then the fund sells short an equal amount of overpriced, shaky shares. If the fund managers invest wisely, the approach will make money in up and down markets. In fact, the JPMorgan fund has generally delivered single-digit returns during up years and excelled in down markets. From November 2007 through this February, the market-neutral fund returned 1.7%, while the S&P 500 lost 51% of its value. During the decade ending in February, the fund returned 3.2% annually, outpacing the S&P 500 by 6.6 percentage points. Why not skip the market-neutral fund and just own bonds? A market-neutral choice can provide important diversification. When interest rates rise, bonds can sink. But a top market-neutral fund can stay in the black almost every year. Protection from a bond bear market could be particularly important these days, since some economists worry that big budget deficits will eventually unleash inflation and drive up interest rates.
One of the most successful absolute-return choices has been Merger Fund ( MERFX), which returned 5.2% annually during the past decade. The fund follows a merger-arbitrage strategy, buying shares of companies that are acquisition targets. In a typical deal, the acquirer seeks to buy shares at a premium to the current market price. After the takeover is announced, the stock rises, but it doesn't reach the bid price because there is uncertainty about whether the deal will close. The Merger Fund profits by buying after the acquisition is announced and then holding until the shares rise to the takeover price. When it succeeds, the merger strategy achieves a series of small gains. Those may seem puny during a bull market. But in today's difficult environment, a fund that produces single-digit returns can help to anchor battered portfolios.