Absolute Return Mutual Funds

What is an absolute return mutual fund? As it turns out, the answer to that question isn't crystal clear. Each company that manages an absolute return mutual fund has a different definition based on the make-up of their mutual fund. But the goal of every absolute return mutual fund is the same — make money regardless of market conditions with lower volatility than traditional mutual funds.

Absolute return strategies came from the hedge fund world, where hedge fund managers have long used various hedging techniques, trying to achieve positive returns regardless of market conditions. Essentially, unlike traditional mutual funds, absolute return mutual funds are designed to perform based on a specific goal -- to outperform a particular, low-risk security type (such as a Treasury bill) in absolute terms. What does all of this mean? Let's look at absolute return mutual funds more closely to understand.

Relative Returns and Absolute Returns

Generally, mutual fund performance is compared relative to a benchmark. For example, a U.S. large-cap equity mutual fund's performance might be compared to the S&P 500 Index, while the return of an international large-cap equity mutual fund would be compared to a benchmark that includes international large-cap stocks, such as the MSCI EAFE Index.

The relative return of a mutual fund measures how well a mutual fund has performed compared to its benchmark. For example, if you own a mutual fund with a return of 10% and the return of its benchmark is 7%, then the relative return is 3%. The absolute return is simply the return of the mutual fund. In this case, the absolute return is 10%.

Relative returns are important because it tells mutual fund investors whether or not they are getting what they paid for — returns in excess of the mutual fund’s benchmark.

Absolute Return Mutual Funds

Would you be happy if your mutual fund beat its benchmark by 10%? For example, if you owned a U.S. large-cap mutual fund and it beat its benchmark S&P 500 Index by 10%, would you be pleased with those results? After all, your mutual fund manager did his/her job — he/she beat their benchmark by a wide margin, right? The relative return was positive. But what if I told you that the benchmark was down 15%? Would you still be happy that your mutual fund beat the benchmark by 10%? After all, you still lost 5% on your holdings.

There is where absolute mutual funds come into play. Absolute return mutual funds are managed with a specific return goal in mind (to beat Treasury bill yields by 2%, for example). The goal of the absolute return mutual fund is to always have a positive return regardless of the market — and regardless of benchmarks.