Putting your money in a fund that can increase your investment whatever the markets might be up to sounds like a foolproof plan.
Especially if you listen to the ominous rumbles that say the good times can’t last forever and that at some point the strong equity growth seen in recent years will slow down.
Since derivatives have become permitted holdings in some unit trusts and other funds such as open-ended investment companies (Oeics), a number of investment houses have sought to attract investors by using these tools within their funds.
The idea is to attract risk-averse investors who are interested in garnering good returns from their investments, but worried about the idea of a stock market crash wiping out all their funds.
What are absolute return funds?
These funds aim to produce positive returns for investors every month regardless of market conditions.
Traditionally most mainstream funds have compared themselves with a certain index such as the FTSE All Share, striving to outperform this index, say, by a few percentage points a year. The aim of absolute return funds is to remove the constraints of a benchmark and allow the manager greater flexibility. Many describe themselves as “cash plus” because they aim to generate returns similar to cash often with an additional return of 1 or 2 percentage points annually.
Is my money definitely safe?
Not usually. Absolute return funds aim to beat cash returns but they tend not to guarantee a minimum return. You can still lose money if your manager takes a risky bet or the markets take an unexpected turn. This is not a precise science and is based on the individual fund manager’s skill in choosing the right blend of investments.
Why don’t I just hold my money in cash?
Although cash offers a very low-risk way to protect your money, over the long term its prospects are very dull, says Justin Modray at Bestinvest. Absolute return funds seek to deliver good long-term returns without volatility.
How do they do this?
There are a number of different methods a fund manager might employ.
At one end of the spectrum are managers who aim to protect the wealth in their funds by using bonds, where returns are less volatile. These are relatively straightforward. Threadneedle’s Absolute Return Bond, for example, invests in fixed interest such as UK government bonds (gilts) and corporate bonds to provide a more stable return and, in this case, also in an attempt to benefit from currency movements.
Others such as the Newton Absolute Intrepid fund will spread investments thinly across a range of asset classes in order to reduce volatility. This can be a more risky strategy and relies on the manager’s ability to judge the right time to shift a fund’s investment holdings in and out of asset classes such as equities or cash and bonds.
More complicated is the use of long and short stocks.
What is long/short investing?
The introduction of new investment freedoms in April 2004 under Ucits III rules allowed funds to use derivatives to go short on stocks, effectively allowing the fund to profit from share price falls. Funds such as the Merrill Lynch Absolute Alpha and SWIP Absolute Return UK Equity funds can therefore benefit from both rising and falling markets.
But advisers say that it is still early days for such funds and that they have yet to face the acid test of a sustained market downturn. As a general rule, absolute return funds are likely to underperform in a rising market as the costs of going short eats into returns. But in a falling market, they should outperform as the short positions boost returns.
Hedge funds, where managers can take long or short positions on a wide range of markets or asset classes, also often have absolute return benchmarks. Funds of hedge funds such as HSBC Global Absolute and Dexion Absolute spread risk by investing in a range of hedge funds. But individual hedge funds can follow a wide range of strategies. While some provide stable returns, others can employ very risky techniques.
Have absolute return funds performed well?
That depends on the type of fund. Some hedge funds have performed spectacularly. Others have lost investors’ money. Some of the more mainstream absolute return funds have had mixed fortunes. The Scottish Widows Absolute Return UK Equity fund has only provided positive returns in half the months since it launched. City Financial Diversified Absolute Return fund has managed positive returns in only 54 per cent of the months since its launch.
Should I invest in them?
Advisers say it depends what you want from your investments. Most absolute return funds are never going to provide returns to write home about.
If you want to make more than cash but are wary of taking on too many risks, some form of absolute return fund could be worth considering but remember that they will charge high performance fees.
Some advisers question whether you need to hold an absolute return fund if you have a sensibly balanced portfolio. By holding other assets such as corporate bonds and commercial property you can endow yourself with a certain amount of protection because these are not correlated to stock markets.
