Their benchmarks lack honor.
By Jason Kephart | 05-15-17 | 06:00 AM | Email Article
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The Seven Samurai
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That terrible one with Tom Cruise

Absolute returns are a popular goal among mutual funds, but investors considering these funds need a better benchmark. We’ve previously covered how funds that target positive returns have generally delivered on the absolute return promise over the past 10 years, but so have traditional asset-allocation funds. You can find that research here. In this piece, we’ll measure whether using “absolute returns” as a benchmark makes sense, by using what’s commonly referred to as the S.A.M.U.R.A.I test. This is a mnemonic device for seven criteria that a valid investment benchmark should meet.

Jason Kephart is a senior analyst covering alternative strategies on Morningstar’s manager research team.

First, a primer on the allure of absolute, or target, return funds. From an investor standpoint, focusing on a target returns makes sense if there are clear spending needs on the horizon. For example, imagine Sam and Rosie Gamgee, who want to fund their child's college education using their investment portfolio without dipping into the principal. With the help of their financial advisor, they decide that a portfolio return of 5% above inflation would meet that goal. In theory, an investment strategy that can provide a minimum return of inflation plus 5% annualized would be ideal.

That’s where one of the more than 80 mutual funds that target absolute returns, rather than returns relative to a static benchmark, might come in handy. Although these funds share the similar outcome-oriented goals, they cover a wide range of investment strategies. Most of these funds, like  William Blair Macro Allocation  and  AQR Style Premia Alternative , fall into alternative categories. Others, like  GMO Benchmark-Free Allocation , fall into traditional allocation categories. Because these target-return funds have similar goals, it may be tempting to solely judge them based on if they hit their target returns over a specified period, usually three- or five-year rolling periods. Before jumping to that conclusion, let’s see how target returns do with each of the seven requirements of a valid benchmark as defined by the S.A.M.U.R.A.I. test.

Specified In Advance--Pass
The first requirement of a valid benchmark is that it is specified in advance. We’ll give target-return funds credit for this one, even though some managers make investors work harder than others to find out what the actual target return is. Putnam Investments wins the award for the most transparent target-return funds in this sense, as the four target-return funds it offers have target-return above cash in the fund names.  Putnam Absolute Return 500 , for example, targets returns of cash plus 5% over rolling three-year periods.

Appropriate for the Manager’s Style and Constraints--Fail
Most reasonable investors would agree that it doesn’t make sense to judge a large-cap value fund’s performance versus a large-cap growth index. Absolute returns don’t have a style because they are literally just a number, but target-return managers can, which means they can fall short of their goal or overshoot it based on whether that style of investing is in favor. When measuring a manager, it is important to separate beta--that is, market or factor returns that an investor can purchase cheaply in an index fund--from alpha, which is a sign of manager skill and much more scarce.

Of the target-return fund managers, some fall firmly in the value investor camp, like GMO Benchmark-Free Allocation and  JHancock Global Absolute Return Strategies , while others like AQR Style Premia Alternative use a mix of factors including value, momentum, and low beta. Despite the different styles, each fund targets returns of at least cash plus 5%.

Because styles can go out of favor for extended periods of time, these tilts can have an adverse effect on performance over short- or medium-term periods. GMO’s value bias, for example, has led to a defensive portfolio that has lagged peers over the trailing five years as stocks and bonds have rallied. Over the five years ended March 31, that fund returned 3.9% versus 1.2% for the US Bureau of Labor Statistics CPI All Urban Not Seasonally Adjusted Index, giving the fund an absolute return of about half its bogy.

Provided the fund states its target return in advance, it is very easy for an investor to measure if it has hit that goal over various time periods.

Target-returns are completely ambiguous. Pick a time period and you are likely to come up with a plethora of various allocations that would reach a target return above cash regardless of the level. Because this is only easily done in hindsight, it is hard to know what mix of assets a manager targeting a given return should invest in.

For example, the managers at AllianzGI Structured Return , an options-based strategy, target the same return over cash, 5%, as the multiasset portfolios run by GMO, JHancock, and a slew of other more global macro-oriented managers. Both funds are using different tool kits to seek to arrive at the same end point.

Reflective of the Manager’s Views--Fail
To construct these target-return portfolios, managers typically use either historical returns, capital market assumptions, or a combination of both to build a multiasset portfolio they expect will hit the overall return target with the minimum amount of volatility. Even if a manager had an incredible track record of forecasting asset-class returns, which most do not, the available mix of asset classes in a daily liquidity vehicle might not add up to the total return target or may far exceed it over any particular time period. Although expected returns are likely to change over time, target-return goals do not fluctuate based on market conditions, at least not that we’ve seen.  

As with the Measurability requirement, as long as the target return is stated in advance, it is easy to hold a manager accountable for meeting or not meeting the goal over a reasonable time period.

Investable at a Low Cost--Fail
One cannot simply walk into a mutual fund store and purchase a low-cost and diversified investment that offers cash plus X% whenever one feels like it. Target-return funds don’t come cheaply either. The average target-return fund has a prospectus net expense ratio of 1.70%.

The Better Benchmark
Targeting a return is not a bad idea when making a financial plan, but, when it comes to measuring a manager’s skill, such benchmarks are not helpful. Instead, investors are better served using a low-cost traditional index allocation fund set to an appropriate level of risk to match the target-return fund as their measuring stick. In our previous study, we used a custom benchmark of 30% equities and 70% fixed income, which reflects the average equity exposure of target-return funds, but investors should use a custom benchmark tailored to their specific funds.

True, relative returns are not as exciting as big round numbers, but they do a better job of reflecting what returns are available to investors over a given market environment for an acceptable level of risk. Investors can then determine whether a target-return manager added value. For investors like the Gamgees, it may be hard to accept less than their desired target return, but the market’s returns are not for them, or target-return managers, to decide. They can only decide what to do with the returns that are given to them.

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Jason Kephart does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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