Using Absolute Return Funds to Protect Yourself From a Falling Stock Market

Using Absolute Return Funds to Protect Yourself From a Falling Stock Market Unless things turn around this year, we will have had a declining market in four of the past five years. Many analysts, me included, are predicting that the next 10 years in the market will not be as good as the past 10 years has been. If we do have a falling stock market, what can an investor do? When you buy an index fund, you expect that if the market goes up your fund will go up. If the market goes down your fund will go down. An absolute return investment strategy is different. If you buy an absolute return fund, you expect it to make money regardless of what the market does. No, this is not one of those sounds too good to be true things. If the market is up 30% you wouldn't expect an absolute return fund to be up 30%, but if the market is down 30% you wouldn't expect your fund to be down 30% either.

The 90's were the decade where beating the market was the most important investment strategy. Index funds marketed themselves by saying that since most actively managed funds don't beat the market investors should just buy index funds. Actively managed funds fought back by showing time periods when they did beat the market. Then came 2000-2002, the market was creamed. Whether you were in an index fund or an actively managed fund didn't matter, you still lost a lot of money.

I believe that this decade will be the decade of absolute return. Investors don't care as much about beating the market they just don't want to lose money. A number of mutual funds have come out over the years, and continue to come out, that follow absolute return strategies. These are as follows:

Long/Short: A long short fund buys stocks it likes and sells short stocks it doesn't. Short selling is a way to profit if a stock declines. A traditional long/short fund might buy 100 stocks it likes and short 100 stocks it doesn't . That way they don't care whether the market goes up or down, they just care that they picked the right stocks to short and the right stocks to buy.

Merger: Merger funds profit from announced mergers. Let's say Coke and Pepsi decide to merge. Pepsi is trading at $45 dollars a share and Coke announces that they will buy all outstanding Pepsi shares for $50 in 30 days. Pepsi will immediately increase in value but it won't go up to $50 because there is a month before the merger is final. Instead, it might go up to $49.50/share. A merger fund would buy Pepsi at $49.50 and hold it for a month, then sell it to Coke for $50. They would keep doing this all year in the hopes that these small profits would start to add up.

Tactical: Most mutual funds have a narrow focus on what types of investments they buy. For example, you may have a fund that buys large growth stocks. If the portfolio manager doesn't think large growth stocks are a good investment there is nothing he can do, he must keep trying to find large growth stocks to buy. A tactical fund puts little or no limits on the portfolio manager. He can buy stocks, bonds, and other financial instruments anywhere in the world.

Asset Allocation: A traditional asset allocation would put some percent of the portfolio in bonds and some percent in stocks. This type of fund will not protect you much from a down market. Some funds, however, are more advanced. They might have some of their money in stocks and bonds but they also may have money in gold, commodities, real estate, etc. to add further diversification and protection.

Hedged: A hedged fund (I am not talking about hedge funds here) picks stocks it likes just like any stock fund. It also might use futures or options to limit or eliminate market risk depending on the portfolio manager's view on the market.

There are a number of non-traditional types of mutual funds that seek to produce positive returns regardless of what the stock market does. Investors might be wise to look into adding some of these funds into their portfolios.