The hot stuff that now looks like a damp squib

Absolute return funds, whereby investors should make money regardless what happens to markets, sound  appealing but have so far failed to live up to their promise.

The funds boast a range of investment strategies aimed at making a profit even if the value of shares or other assets fall, including selling stocks “short” and using derivative tools such as betting against an index.

But if such funds use complicated financial tools, all have a basic promise to try to deliver low-risk steady growth, normally set above the rate of return from cash holdings, regardless of market conditions.

The concept is attractive, particularly given worries of a potential market correction. Absolute return funds should mitigate losses, and potentially even profit from adverse conditions.

But the theory has so far not lived up to the fact, says Justin Modray, head of research at Bestinvest. “These funds could be destined to perpetually disappoint,” he says. “Fixed target return funds have left many investors feeling short-changed by failing to hit targets.”

A recent study by Standard & Poor’s, which rates 21 euro-denominated absolute return funds, revealed that none achieved their return target after fees in 2006. Only four outperformed cash returns, meaning that it would have been better to bank the cash rather than invest in the funds.

Most of the funds rated had a portfolio based in bonds, says Kate Hollis, Standard & Poor’s analyst. Bonds had a particularly difficult year in 2006.

Figures from Bestinvest support the S&P research. Of the 11 funds that Bestinvest includes in its coverage of the mainstream absolute return market, only four met targets in the 12 months to June. Most managed to beat a cash return but two dropped in value in that time.

One of the most glaring underperformers was Barings Directional Global Bond trust. Despite one of the highest management fees of 1.75 per cent, and one of the most ambitious target promises of 4 per cent above the bank lending rate, this fund dropped almost 6 per cent in value in the 12 months to the end of June.

Investors also need to be aware of the fees involved in the funds, says Modray, as these can also drag on overall returns.

Bestinvest includes a number of different groups in its definition of absolute return funds, which highlights the fact that the term is used to cover a range of techniques.

The most common is based around fixed- income products that aim to provide a stable income, although will normally also have some exposure to equities and other asset classes.

Other funds offer a more traditional “long/short” hedge fund strategy, which means the manager will be as likely to sell assets “short”, thereby hoping to profit from market falls, as buy into them for a “long” exposure. The range of hedging will normally range from zero per cent short to 100 per cent short, depending on market conditions.

Some of these funds will invest only in equities, such as the Merrill Lynch UK Absolute Alpha, while others try to spread the risk across a very diversified portfolio.

New Star Diversified Absolute Return, for example, can invest in anything from zero dividend preference shares, effectively bonds issued by building societies, and fixed-interest securities to investment trusts, money market instruments, cash deposits and any other asset deemed appropriate to meet its absolute return goal.

Similarly, the JPMorgan Cautious Total Return fund has a broad, multi-asset approach, according to portfolio manager Talib Sheikh. He says JPMorgan sees this as offering the best bet for an absolute return fund.

“There is no single ultimate way to set up an absolute return fund but we see the multi-asset approach as working best. No single asset class gives sustained returns over the long term, so you need to be able to switch in and out of areas as they do well.”

Sheikh says the JPMorgan fund has beaten a cash return but has not met its target of 3 per cent above the base rate because of the difficulties in the fixed-income market.

“Absolute return funds have to hold up their hands and say that they haven’t met targets but it is still a new industry and over the longer term we see it as performing well within its parameters,” says Sheikh.

Given the broad range of potential fund techniques, Modray says investors need to be careful about what they buy into. Different funds inevitably give different results at points in the market given their various asset allocations.

Robert Waugh, head of UK equities at Scottish Widows Investment Partnership, who runs the Scottish Widows Absolute Return UK Equity fund, admits the absolute badge can be confusing. “People have to understand what they are buying into. They need to look behind the name and study what the strategy is and if it works for them,” he says.

It is not surprising, Modray says, that the funds that have outperformed to date have been those rooted in equities. One of the best performing funds is Merrill Lynch UK Absolute Alpha, which returned 11.9 per cent in the year to June.

Similarly, the Scottish Widows Absolute Return UK Equity fund has also met its target of 4 per cent above Libor, the interbank lending rate. The fund invests in 30 stocks and then uses futures or put options to hedge against the risk of these equities.

Waugh says that looking simply at returns on absolute return funds can be misleading – almost as important is volatility. “Our volatility is three times less than the market average. Historically, people have invested because of returns. But absolute return funds are about risk as well. If an investor wants equity-like returns then invest into equities, but they will also face the risks of doing so in today’s market,” he says.

The acid test of absolute return funds, says Modray, will be a sustained market drop.

Hollis agrees that part of the reason for their lacklustre performance to date has been market conditions. “They ought to outperform in a bear market,” says Hollis, “when the only way to really make money is a net short position.”

Given the relative infancy of the market, few funds have been tested under such conditions. Fund launches began in 2005, which means that many do not have a track record of much longer than a year.

Alex Hoctor-Duncan, head of retail business at Blackrock, which manages the Merrill Lynch fund, says it takes a “market neutral” position, meaning that it has equal amounts of long and short positions from trading pairs, for example buying GlaxoSmithKline but selling AstraZeneca. This, he says, controls volatility and provides steady returns, meaning it is well protected against market downturns.

When the market took a 4 per cent dip in February, for example, Merrill Lynch UK Absolute Alpha only dropped 0.2 per cent.

“The idea is to get smooth returns with a low volatility regardless of market conditions. We don’t put a target return on our fund – that is the wrong approach,” says Hoctor-Duncan.

Ultimately, Waugh says that investors should see absolute return funds as an important savings alternative given their promise of cash plus a bit more with low risk. “Why bother insuring your house? It is because of what might happen to it. It’s the same with savings. I have all my savings in my fund, which I think is a right thing to do given the market at the moment.”