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Mutual Funds

The Illusion of Guaranteed Gains

A new breed of funds promises more than we think they'll deliver.

The name says it all. Absolute-return funds aim to deliver modest gains in almost any market environment with low volatility and less risk. With investors bruised by two bear markets in a decade, who wouldn't reach for that brass ring? Many already have. More than a dozen mutual funds with an absolute-return mandate have launched just since 2008. Assets within the category have grown to roughly $4.9 billion. Robert Reynolds, chief executive of Putnam Investments, which introduced four absolute-return funds in 2008, predicts that such funds will one day claim as much as one-fourth of mutual fund assets.

Before you join the crowd, though, be aware that these complex investments are not easily analyzed, and it's likely that many won't deliver on their promise. The good funds will let ordinary investors in on opportunities that were once reserved for hedge-fund moguls. But others will likely turn out to be flavor-of-the-month marketing gimmicks. For now, differentiating between the two groups is no easy task.

For starters, there is no agreement on which funds belong in the category. Funds may not have the words absolute return in their names. The common denominator, however, is a mandate to deliver consistent gains in any market and avoid losses. One hallmark of the funds is that they don't always move in the same direction as traditional asset classes. They may, at various times, employ long positions or short-selling strategies, and invest in domestic or foreign stocks, bonds, currencies, or derivatives. Fund trackers currently lump the funds in with other categories (you may find them labeled "short-term bond" or "market neutral," for example). With so much category confusion, it's hard to assess a fund's performance within a peer group.

Nor is it easy to determine a benchmark. Absolute-return funds are typically not measured against what they invest in, the way a traditional stock fund might be compared with Standard & Poor's 500-stock index. Rather, success is measured by whether a fund beats a risk-free rate of return -- as you'd get from Treasury bills, say -- and by how much. Few absolute-return funds have track records long enough to indicate whether managers have hit their marks.

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The promise of all-weather gains comes at a price. Many absolute-return funds carry a sales charge, and expense ratios are steep -- 1.8%, on average, compared with 1.4% for the average stock fund and 1.0% for the average bond fund.

Investors who can look past the hype and are patient enough to be selective may find a few gems among absolute-return funds. Though still cautious, analysts at Litman/Gregory Asset Management -- publisher of the No-Load Fund Analyst newsletter -- see promise in absolute-return strategies, especially given the firm's five-year outlook for lackluster returns from traditional stock and bond investments. Among funds that Litman/Gregory likes and puts in the absolute-return camp are Pimco Unconstrained Bond D (symbol PUBDX) and Arbitrage Fund (ARBFX). (For more on Pimco Unconstrained, see The Best All-in-One Bond Funds. Arbitrage Fund is a new member of the Kiplinger 25; for details, see Our 25 Favorite Funds.