Alternative investment funds, such as hedge funds, have traditionally been a vehicle for wealthy individuals, institutions and other “sophisticated” investors. These funds typically have high barriers to entry – like $1 million minimums, accredited investor requirements and extended lockup periods. With investment hurdles and qualifications like that, the average investor does not normally have access to a wide variety of these funds.

There are, however, a number of mutual funds that offer “absolute return strategies” that aim to deliver positive performance in up and down markets. Absolute return strategies are contrary to relative returns strategies, where managers focus on performance relative to a certain benchmark, such as the S&P 500 or the Russell 3000 Index. For example, a portfolio manager would consider a loss of 10% in a given year, versus a loss of 15% for the best-fit index, a success.

Like hedge funds, absolute return funds will short stocks, or sell borrowed shares with the intention to buy them back later, ideally at a cheaper price, when the outlook on the market is negative. This creates a hedge, where the manager could potentially make money in up and down markets on a consistent basis, while at the same time reducing the volatility of the fund’s returns. Some managers will attempt to match the exposures of the stocks they buy long and stocks they sell short (known as pair trading or market neutral), in order to establish a neutral exposure to the market or certain sectors (For example, they may be 50% long and 50% short).

If implemented effectively, the manager can eliminate the effects of market movements, or minimize the fund’s beta. This will leave performance to be primarily derived from picking stocks, or solely on the manager’s ability to generate alpha. In general, absolute return strategies have lower volatilities than relative return strategies.

These alternative mutual funds have gained popularity in recent months, mostly from investors who do not want to risk losing money when the stock market is down. On the flip side, however, the investor will likely give up some upside potential when the stock market moves ahead. For example, absolute return vehicles may aim to provide returns of between 8-10% per annum, regardless of the overall stock market’s direction. In Year 1 an investor would likely be happy with a gain of 10% when the stock market is down 5%. But, the same investor may be disappointed in Year 2 when the market is ahead 20%, while the absolute return fund is only making 10%.

Also, funds like these usually come with a price. On average, their fees are higher due to the uniqueness of their strategies and additional costs associated with short-selling stocks.

Three Examples of Absolute Return Strategy Mutual Funds

Diamond Hill Focus Long/Short
We recently spoke with Ric Dillon, the CIO and President of Diamond Hill Funds and the co-portfolio manager of the Diamond Hill Focus Long/Short Fund. This fund was originally launched as a hedge fund and later made available to retail investors as a mutual fund in 2000. Ric and Chuck Bath (co-portfolio manager) use bottom-up fundamental analysis to identify large- and small-cap stocks that are selling at a discount to their intrinsic value. The team also looks for companies with sound management, a competitive edge and strong free cash flow. Ric and Chuck will also short stocks that they find to be overvalued by the market, and which often show the opposite characteristics of their long ideas. In general, they will have a long stock bias (percentage of long stocks is greater than the percentage of short stocks in the portfolio). The fund is run in a risk-controlled fashion with a long-term investment horizon of around five years (on both the long and short side), which can been seen by the fund’s low annual turnover of 18%.

Through February 2006	YTD	2005	3 Year Annualized	5 Year Annualized
Diamond Hill Focus Long/Short	3.6%	21.5%	24.4%	9.0%
S&P 500 Index	2.9%	4.9%	17.1%	2.4%
Rank in Long/Short Peer Group	Top 30%	Top 5%	Top 1%	Top 5%

Merger Fund
The Merger Fund also falls into the long-short category, and seeks to provide absolute returns of 10-15% per year, regardless of the direction of the stock market. The fund manager’s strategy is a bit different than Diamond Hill’s. The Merger Fund uses a strategy called merger arbitrage, which primarily entails buying the stock of acquisition targets, and selling short the stock of the acquiring firm. If the merger deal closes, the fund will make money, as the stock of the target firm generally appreciates, while the stock of the acquiring firm tends to depreciate.

One risk of this type of strategy is the supply of merger deals. If there is a lack of merger activity, or if there is too much money chasing these types of deals, it may put a damper on returns.

However, Merger Fund management does not see a slowdown in merger activity, and has recently reopened this fund for that reason. Also, this fund has the longest history of any fund in this space, and with managers Frederick Green and Bonnie Smith at the helm since 1989, they certainly have the experience to identify new opportunities.

Through February 2006	YTD	2005	3 Year Annualized	5 Year Annualized	10 Year Annualized
Merger Fund	3.3%	0.8%	5.8%	2.2%	7.1%
S&P 500 Index	2.9%	4.9%	17.1%	2.4%	8.9%
Rank in Long/Short Peer Group	Top 40%	Top 50%	Top 49%	Bottom 25%	Bottom 33%

Absolute Strategies Fund
The Absolute Strategies Fund, which launched in July of 2005, is managed by Absolute Investment Advisers out of Hingham, MA. As its name implies, the fund focuses on achieving absolute returns with low correlation and low volatility relative to the broader markets. The difference is that the managers use a multi-strategy approach by allocating up to 20% of their assets to different highly skilled and established money managers whose strategies pursue absolute or risk-adjusted returns.

To create less-volatile long-term returns, the fund uses a quantitative approach to diversification and risk management by blending together managers and their strategies. In addition, the fund’s analysts use an extensive qualitative review to help them select their sub-advisers. In many ways, this vehicle resembles a hedge fund of funds, with the differences being daily liquidity, a lower minimum investment, portfolio transparency and a reduced risk of fraud, as all assets are held with Citigroup. Instead of allocating assets directly to the alternative managers, assets stay with the above-mentioned custodian and each sub-adviser instructs trades just for the portion of assets they manage.

Through February 2006	YTD	Since Inception (7/05)
Absolute Strategies Fund	1.5%	2.2%
S&P 500 Index	2.9%	8.9%
Rank in Long/Short Peer Group	Bottom 40%	NA

In Summary
In summary, a small allocation to an absolute return strategy may be a beneficial addition to a portfolio of long-only mutual funds. Absolute return strategies tend to have a lower correlation to the broad market and may help diversify a portfolio of funds, thereby reducing the overall volatility of returns. Before investing in this area, it is important to understand exactly what you can expect from the strategy, and how it may fit in to your portfolio.

-- Gordon Barnes