The financial markets were definitely disrupted in 2008-2009, which is a little scary for investors but industry disruptions often lead to new innovations. Some new products are good, others are bad and some could be good but just have really bad execution. Today’s article is about a great idea that can be done well or very poorly.

Video Analysis: Absolute Return Funds

“Absolute return funds” is the title given to a growing mutual fund segment currently promising above inflation returns with smooth profitable performance. This is a compelling marketing pitch considering the concerns about inflation and volatility in the market today.

The funds are proposing to deliver these returns and stability though active management and asset class diversification.

The active management for this style of fund can be described as pretty extreme. The fund managers will use market timing techniques to move from short to long positions and changing exposure levels to different asset classes as they see fit.

This level of flexibility is usually associated with hedge funds. Of course, all this flexibility comes at a steep price in fees that can really add up.

For example, the Putnam Absolute Return Fund 500 will charge you 5% to buy and 2.25% annual fees to compensate management. That seems a little extreme and can soak up a lot of profits.

Paying 2.25% per year means that in 10 years you will have paid the management team almost 17% of your total portfolio regardless of returns. High fees and big promises are typical of this style of fund.

The question becomes whether the manager’s talent can actually make those high fees worthwhile. Evidence would suggest that it is not worth it.

For example, we searched the Putnam site for other funds managed by the Absolute Return Fund 500 manager to see what his track record was like. Of the first 5 funds we found, he had not been able to outperform reasonable benchmarks in the long term. This certainly throws doubt on their forecasted performance within this new series of funds.

This is typical of most of these kinds of funds. They charge a lot and have very nice marketing materials but fail to deliver results. For a little more detail about the average performance of managed funds compared to indexed funds, here is a great report from the University of Albany.

Active management is expensive and on average does not outperform passive indexing. However, it is important to keep in mind that the strategic ideas of asset class diversification is still a good one.

The good news is that you don’t need to pay anyone exorbitant fees to do this kind of investing. If you want to diversify your portfolio beyond stocks and into bonds, commodities, options, forex etc. you can do it with indexed ETFs and funds. Keep your fees and learn how to do this kind of investing by starting here.

Image courtesy Hitchster.