Falling markets spur flight to safety

Better performance by absolute return funds, which aim to profit in both bull and bear markets, is bringing them back into fashion.

Figures from Cofunds, the fund provider, show that net sales of funds listed in the Investment Management Association (IMA) absolute return sector – launched just last year – more than tripled from £4.81m last November to £17.5m in January as markets fell. This resurgence of interest has led Gartmore, SVM, Standard Life, Liontrust and Insight to promote absolute return funds, run by ex-hedge fund managers in many cases.

An average return of 10.7 per cent from the funds in the IMA absolute return sector in the past 12 months has clearly attracted more investors – and some of those those who invested a year ago have enjoyed returns as high as 20 per cent.

In 2007, though, few were entrusting their cash to absolute return funds. European investors withdrew money en masse, having lost confidence in the funds’ ability to protect them from falling markets.

In the previous year, every single absolute return fund rated by Standard & Poor’s failed to hit its return target after fees, with most funds failing even to match the returns of cash.

But, in the last year and a half, as share prices have plummeted, improving returns and new strategies taken from the hedge fund industry have drawn in investors seeking a positive return with lower volatility.

Absolute return funds aim to outperform cash, typically measured by the London interbank lending rate (Libor) or Euribor, by between 100 and 400 basis points, in all market conditions.

Bestinvest, the advisory firm, includes a number of sub-categories in its definition of absolute return funds, which highlights the fact that the term is used to cover a range of strategies.

Most funds use fixed-interest securities to provide a stable income, with some exposure to equities and other asset classes.

But many funds now adopt 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 and hold them for “long” exposure. The extent of this hedging will normally range from zero per cent short to 100 per cent short, depending on market conditions.

Some of these long/short funds will invest only in equities, such as BlackRock’s UK Absolute Alpha, while others try to spread the risk across a very diversified portfolio.

“A broad church of strategies from market-neutral ones to directional strategies is now available and these fulfil different needs for advisers, portfolio managers and private investors,” points out Richard Pursglove, head of UK retail at Gartmore. which launched a UK absolute return fund this year, still in its offer period. “We’ve got sufficient strategies to bring a suite of these products to the market over time,” he adds.

Gartmore’s UK absolute return takes long and short positions in companies conducting most of their business in the UK. It follows the introduction of the Gartmore European absolute return fund, which mirrors its manager Roger Guy’s existing hedge fund Alphagen Capella.

Other funds unveiled in recent weeks include BlackRock’s European Absolute Alpha fund, headed by former Scottish Widows Investment Partnership manager Vincent Devlin, who runs the firm’s Continental European Fund as well, and SVM’s UK Absolute Alpha Fund, overseen by Colin McLean. Devlin favours “pairs” trading, which involves buying shares in one company and shorting those of a company with similar characteristics in the same sector. Pairs trading is also the core strategy of the Absolute Insight UK Equity Market Neutral fund.

“Provided the first company’s shares do better than the second’s, whether they go up or down, the fund will be in profit,” explains Mark Dampier, head of research at the advisory firm Hargreaves Lansdown.

McLean’s UK Absolute Alpha fund, meanwhile, tends to favour shorting stocks – or betting that they will fail.

However, the management charges can erode returns. For example, a 20 per cent performance fee is levied by the SVM fund if its annual return is higher than the three-month Libor rate, now at less than 2 per cent. This comes on top of the annual management fee of 1.5 per cent.

As a result, some advisers expect absolute return funds will become less popular if equities markets recover strongly.

A “1990s-style” rush to low-risk index funds would quickly replace the current trend if equities rise, predicts Nick Sketch, senior investment manager with Rensburg Sheppards.

“Investors will always tend to buy this year what they now wish they had owned last year – and this will not always be a help to the absolute return sector,” Sketch warns. “If equity markets rise for a couple of years from today’s level (which is not actually impossible), low equity correlation will quickly become a weak sales pitch.”

Absolute returns fund fees will also start to look like poor value, he argues.

“If low nominal returns persist, whether or not markets are volatile, many managers will not be able to produce enough performance at the gross level to be able to justify today’s fees,” says Sketch. “Given the total fees involved, I do not expect the average fund in the absolute return sector to please its investors over the next five or 10 years.”

Others express similar views, arguing that investors now want simpler products carrying lower fees. And as more investors dip into equities, they will do so with considerable caution, predicts Rob Fisher, Fidelity’s head of UK personal investment.

“Complexity is out, simplicity and transparency are in,” he says. “As they return, it seems likely to us that demand will be strongest for straightforward investment products such as corporate bond and UK equity funds for income, as well as managed funds for longer-term growth,” he concludes.