Mutual funds that claim more reward with less risk

There are trade-offs involved in every investment, and sure things tend to be anything but. Nonetheless, in recent years Wall Street has created investments that seemingly offer all the returns without some, or any, of the risk. Here's a rundown of three widely hyped ones.

Low-volatility funds

The claim: They can match or exceed the returns of the overall stock market while minimizing downside risk.

The evidence: We're fans of the dependable earnings and dividends that most low-volatility stock funds provide, but that doesn't mean they won't sometimes lose money, or even more likely, underperform the overall market. For example, a low-volatility portfolio would have lost money in the 2008 bear market, though not as much as the market as a whole. What's more, when tech stocks were climbing into the stratosphere in the late 1990s, low-volatility stocks remained relatively earthbound.

When you examine them closely, most low-volatility funds are heavily invested in utilities, consumer staples, and health-care stocks. So they're largely indistinguishable from many other funds that focus on dividend-paying stocks. Consider the fact that half of the stocks in the iShares High Dividend Equity ETF (ticker HDV) are exactly the same as those in the most popular low-volatility fund, the PowerShares Low-Volatility ETF (SPLV). There are subtle differences, but the end result is similar. Fortunately, since it's an exchange-traded fund, this isn't a case of investors paying too much for a fancy label: The PowerShares ETF has a thrifty 0.25 percent annual expense ratio.

Read more about strategies for building emergency savings.

Long/short funds

The claim: Their managers can deliver higher returns through a special two-part strategy: buying stocks that they think will outperform the market (the "long" part of the fund) and betting against stocks that they think will underperform (the "short" position).

The evidence: Although classified as an alternative investment, long/short funds are essentially stock funds with a twist. But stock picking is still stock picking, and in time most active fund managers underperform the broader market.

Long/short funds prove to be no exception. Using data from Morningstar, we screened for long/short funds that currently manage at least $25 million in assets. It turns out that only half of those long/short funds with a five-year track record bested the Standard & Poor's 500 index's annualized total return of 0.4 percent during that five-year period.

Recent results are even worse: Only one of the 49 long/short funds beat the one-year S&P 500 total return of 16 percent for the period ending Nov. 30, 2012.

The hyperactivity of those funds probably doesn't help their returns either. Long/short funds engage in more trading than ordinary stock funds, turning over at a rate of more than 200 percent annually in many cases. By comparison, stock funds have a 58 percent annual turnover, on average, according to the Investment Company Institute. In turn, trading costs result in relatively expensive prod-ucts. Most long/short funds have expenses in excess of 1.5 percent annually, compared with an average 0.93 percent for other actively managed stock funds and 0.14 percent for index funds.

Absolute-return funds

The claim: Perhaps this is the free-lunchiest of all the recent offerings. Absolute-return funds promise a positive return regardless of market conditions. How? By employing some of the same tactics as long/short funds, along with debt and currency hedging.

The evidence: Many of those funds have been failures so far, unable to achieve their goal of consistently positive returns. Most have lagged the broader stock market, which has doubled in value over the past four years—while making no guarantees to investors.

—Chris Horymski

This article also appeared in the May 2014 issue of Consumer Reports Money Adviser.

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