Q: What are absolute-return funds? Are they a good idea?

–K. Kittelson Greenwood Lake, NY

A: Although absolute return strategies are nothing new–hedge funds have deployed them for years–their incursion into the mutual fund sphere first occurred earlier this decade and has picked up in earnest.

Basically, fund managers structure the portfolio so that each holding is balanced by another position that exhibits converse volatility characteristics–that is, when the value of one holding goes down, the other should go up.

Such an approach limits the amount of selling required to adjust the portfolio to changing market conditions. Others funds employ a long/short strategy, investing in stocks but also betting against them.

The funds aim to generate positive absolute returns over a specific period, with the horizons on most offerings set for three to seven years.

Do absolute-return funds work for investors? The jury is out.

The RiverSource Absolute Return Currency and Income Fund (RARAX), for example, generated a positive return last year, while a number of recently launched funds from Putnam Investments are also in positive territory.

But absolute-return funds make little sense for most investors. Recent studies have shown that individual investors can often achieve similar, if not better, results by maintaining a diversified portfolio. The high price tags associated with these funds eats into returns; most absolute-return offerings carry front-end loads of around 3 percent, in addition to steep expense ratios in the neighborhood of 2 percent.

We recommend that most individual investors avoid these funds.

Q: What does a mutual fund’s expense ratio consist of?

–L. Dillon, Oxford, KS

A: All mutual fund investors face annual charges and deductions for various ongoing expenses, the majority of which are tabulated in a fund’s expense ratio, a figure that expresses these charges as a percentage of overall assets.

There are several elements to the expense ratio. Management fees are paid out of the fund’s assets to compensate the financial professionals who construct and maintain the fund’s investment portfolio. This category also includes any administrative fees, which pay for mailing prospectuses, annual reports and account statements to shareholders.

It’s important to note that expense ratios don’t account for sales loads.

So-called 12b-1 charges constitute another major component of the expense ratio and are paid out of the fund’s assets. Charges that fall under this heading generally relate to marketing and distribution expenses, as outlined by the US Securities and Exchange Commission.

In some ways, marketing and distribution fees benefit investors: Advertising the fund should increase its assets, which in turn provides better economies of scale and lowers operating expenses.

At the same time, however, 12b-1 fees oftentimes further enrich brokers that sell the fund to clients, raising questions about the extent to which personal gains trump sound financial advice. Prospective investors can determine exactly how much a fund spent on broker compensation by consulting its statement of additional information.

A fund company’s 12b-1 plan may also include fees related to shareholder services–for example, to hire staff that respond to investor inquiries and provide shareholders with information about their investment.

Q: What’s the story with exchange-traded funds (ETFs) that focus on commodities futures? Are these vehicles still an attractive way for individual investors to play the commodities markets?
—Henry Flynt

A: Over the past few years individual investors have flocked to commodities ETFs, especially funds that trade in higher volumes and offer lower expenses.

These investment vehicles first came under regulatory scrutiny in the summer of 2008, when skyrocketing energy prices prompted legislators to pressure the Commodities Futures Trading

Commission CFTC) to investigate the extent to which commodities ETFs contribute to speculation. Once oil plummeted to new lows, legislative and regulatory scrutiny appeared to subside.

But lawmakers once again have commodities ETFs in their sights. Earlier this summer the Senate Permanent Subcommittee on Investigations released an extensive report on wheat futures which concluded that positions held by commodity index trackers had caused rising prices, added volatility and a decoupling between futures prices and prices for actual wheat.

In the wake of this report, the CFTC instituted position limits on PowerShares DB Agriculture Fund (NYSE: DBA) and PowerShares DB Commodity Index Tracking Fund (NYSE: DBC), forcing the funds to pare back some of their positions and seek alternative investments that increased tracking error. At the same time, the Securities and Exchange Commission refused US

Natural Gas Fund’s (NYSE: UNG) request to issue additional shares to sate investor demand.

Although the prospects for further regulation remains uncertain, we still recommend that investors limit their exposure to larger commodities ETFs that are approaching their predefined position limits.

We’re always happy to get receive subscriber comments and questions by e-mail at service@rukeyser.com or by telephone at 800-832-2330.