An important role for an investment adviser is protecting clients from Wall Street. The toxic assets now threatening the very existence of large banks worldwide were the product of promoters (hucksters, really) on what Wall Street euphemistically calls the “sell side” of the investment business. It’s these promoters from whom investors need protecting.
Let’s take a skeptic’s look at the new “Absolute Return” funds now being marketed by mutual fund operator, Putnam. Are they good for investors? In the opening paragraph of the funds’ prospectus, Putnam states: “Each fund seeks to earn a positive total return that exceeds the rate of inflation by a targeted amount over a reasonable period of time regardless of market conditions.”
There are four flavors of the new Absolute Return funds—called 100, 300, 500 and 700, respectively—like a car that comes with four different engines. The 100 fund seeks to best inflation by 1 percent per year, the 300 fund by 3 percent and so forth.
Wouldn’t a rational investor interpret the phrase “regardless of market conditions” to mean he or she will achieve that positive return regardless of whether the financial markets go up or down? Let’s look again at that prospectus: “…if this strategy is successful, investors should expect the funds to outperform the general securities market during periods of flat or negative market performance, to underperform during periods of strong positive market performance, and typically to produce less volatile returns than general securities markets.”
The idea of absolute return would be very attractive to, say, an endowment or foundation that plans to spend 5 percent of its capital each year and wants assurance it can do so indefinitely despite inflation. Indeed, generating steady returns above inflation, with little or no volatility, is the holy grail of investment management. Achieving absolute returns of the magnitude suggested by the Putnam prospectus sounds very appealing to most investors which, of course, is why Putnam is marketing these funds.
“Absolute return” is a term ordinarily associated with hedge funds. And hedge funds are known for being very secretive about the strategies they employ to achieve their investment goals. What does Putnam tell us about its strategy for these funds?
Let’s look again at the prospectus, where we find the phrase, “if this strategy is successful.” What’s the likelihood Putnam’s strategy will be successful? Indeed, what’s the strategy?
There are 15 pages of text in the prospectus describing the strategies and their associated risks. Initially, we find the four funds divided into two groups. The 100 and 300 funds will employ “a broadly diversified portfolio reflecting uncorrelated fixed-income strategies designed to exploit market inefficiencies across global markets and fixed-income sectors.”
The 500 and 700 funds, we learn, will employ both an alpha strategy and a beta strategy. The alpha strategy involves: “…the potential use of various ‘overlay’ strategies. These consist of diverse active trading strategies designed to provide additional total return through the exploitation of market inefficiencies and other conditions, including trading strategies involving active security selection, tactical asset allocation, currency transactions and options transactions.” The beta strategy “consists of a globally diversified asset allocation strategy. It seeks to balance risk and to provide positive total return by investing, without limit, in many different asset classes, including…[a list of seven different asset classes follows].”
We also learn that, in addition to investments paid for with cash, Putnam expects to use derivatives “to seek enhanced returns” and “leverage its exposure.” And, at several places in the prospectus, Putnam repeats that the funds will use leverage to enhance returns.
It’d be charitable to call those 15 pages a string of investment platitudes. In reality, they describe no strategy at all. I conclude from them that the manager either has no clue how it will achieve the stated goals or is trying to hide the ball.
Ah, you say, let’s look at the manager’s track to determine the strategies used in the past and their success or lack thereof. Only after 56 pages of dense text do we come to a two-page appendix that tells us the funds are “newly organized and have no track record of their own.”
Apparently to give us some assurance that the manager knows its trade, the appendix then presents results for what it calls “other accounts” that have been invested in a “substantially similar fashion” to “illustrate the past performance of Putnam Management’s affiliates in managing substantially similar accounts.” So the illustration is applicable to only one of the four funds—but that’s better than nothing, right?
Despite assuring us that all members of the team managing the funds played a role in managing the other accounts, Putnam proceeds to list reasons the other accounts’ results might not be repeatable in managing the absolute return funds. For the sake of those investing in these new funds, let’s hope the results in the other accounts aren’t repeated in the Absolute Return funds. Because at the very end of the appendix, we learn that, from inception on July 31, 2006 through September 30, 2008, barely more than two years, the composite annual return for the other accounts was 3.82 percent, while the returns for the Treasury bills that serve as the benchmark for the Absolute Return funds was 4.24 percent for the same period.
Remember that the 500 fund is expected to generate returns 5 percent above the Treasury bill benchmark, or 9.24 percent for the period examined. Not only do the funds being sold to the public not have a track record, but the very limited track record of the other accounts offered to illustrate the 500 fund shows underperformance of the benchmark by 5.5 percent a year.
Some years ago, Neil Hennessy, founder of Hennessy Funds in Novato, told me the SEC wouldn’t approve new mutual funds based only on a good idea. Having approved the sale of Putnam’s Absolute Return funds to a gullible public, I guess the SEC ain’t what it used to be.
