Fueling these strategies is the increased demand by investors to diversify away from passive investments. Relative-return products–those focused on a benchmark, such as the S&P 500 index–traditionally do well during periods of strong market performance; however, these products usually do not attempt to manage risk and volatility during difficult times. Investors have been limited in their choice of products that seek absolute returns.

Hedge funds have been one of the most popular alternatives for investors looking to reduce overall portfolio risk and volatility, but this strategy continues to present significant concerns for many. In addition to their large investment minimums, hedge funds may deter investors because of their lack of transparency, substantial fees, extended lock-up agreements and overall complexity.

Facing a sustained low-return environment and lacking viable opportunities to provide investors with enhanced returns, a number of large funds, as well as smaller niche investment managers, reexamined the investment capabilities of mutual funds and created this new class of hybrid mutual fund that emphasizes positive returns and low correlation to traditional market indices. Morningstar, which recently adopted a new category for long-short mutual funds that includes several of these hybrids, reports that there are more than 50 such funds available to investors, with combined assets of roughly $18 billion.

Absolute-return mutual funds may use investment strategies and techniques usually associated with hedge funds, such as short selling and arbitrage strategies, in an attempt to provide hedge fund-like results. As an example of hedge fund performance, over the past five years, the Credit Suisse/Tremont Hedge Fund index has had average annual returns of 8.63 percent, versus 2.36 percent for S&P 500, while providing low correlation and low volatility relative to the broader markets.

In addition to boosting diversification and seeking to lower overall portfolio volatility, absolute-return mutual funds may not involve the same complexity of due diligence as traditional hedge funds. Because these funds are registered with the SEC, investors enjoy a higher level of transparency and disclosure. In addition, mutual fund assets are held by an independent custodian as opposed to money invested in a private placement vehicle.

Alternative to Alternatives
Use of absolute-return investments as an alternative to fixed-income investments has also caught on with financial advisors. With a similar expected risk/return profile, some absolute-return mutual funds may insulate investors from lackluster bond performance and rising interest rates, while potentially offering higher expected returns.

Some investors continue to remain cautious about hybrids, pointing to the potential for reduced performance in rising markets. Because of their low correlation to traditional financial indices, absolute-return mutual funds may not capture the same returns as relative-return vehicles during a period of rapid market growth. And because these funds employ strategies that require greater skill and, in some cases, access to multimanager strategies, fee structures may be greater than those with conventional single-manager mutual funds. Still, fees tend to be significantly lower than those of average hedge funds.

Advisors and investors are wise to understand each fund’s objective in the prospectus and to closely examine single-manager funds, which can lead to single-manager risk. Investors should avoid managers who do not have experience managing money through sophisticated alternative strategies such as short selling.

But the risk of not using these strategies can be higher than the risk of using them. Absolute-return mutual funds can lessen the impact of market volatility on a portfolio and might just add solid returns along the way.

Jay Compson is cofounder and principal of Absolute Investment Advisers and a portfolio manager for the Absolute Strategies Fund.