Range of absolute return funds widened

Investors are being offered a widening range of absolute return funds following a recent change in European regulations that gives fund managers much more freedom to protect against downside risk.

Under what is known as Ucits III – a European Union directive covering collective investments (see box opposite page) – fund managers can now invest in derivatives. This means they can now cover themselves against declines in the price of securities by buying and selling futures and options.

Unlike funds that measure themselves against a benchmark, absolute return funds attempt to make money whatever is happening in the market place. Benchmarked funds, in contrast, may outperform a particular index but still fail to make money for investors if stock markets fall.

If the new funds can deliver on their promises, investors should be happy. But the new funds are seen by some as offering a similar investment profile to the with-profits funds that failed so spectacularly to deliver value in the 1990s.

With-profits funds attempted to smooth the investment cycle by retaining profits from the good years to make up for the bad. But when markets turned down the funds failed to perform and investors complained that the payouts on these policies lacked transparency.

“With the with-profits funds you were never sure what belonged to the insurance company’s shareholders and what belonged to the investors,” says one fund manager. “Nor could you see what charges were being taken out. The new funds, in contrast, are see-through products with investments that are held on a mark-to-market basis and priced through the day.”

Like the old-style with-profits funds, the new funds will also attempt to smooth out the wilder swings of the investment cycle. But the protection they offer against downside risk can put a drag on performance when markets are racing away.

“They are potentially a ‘get rich slowly’ vehicle, which is what the old “with-profits” funds set out to do,” says Paul Ilott, senior investment adviser at Bates Investment Services. “They aim to take relatively low risks to produce positive returns in all market conditions. But they won’t be sparkling when returns are good because shorting the market will act as a drag on the fund’s returns.”

Funds that have been launched recently include the UBS Absolute Return Bond, the Credit Suisse Target Return and the Insight Diversified Target Return. Subscriptions have also just opened for the Threadneedle Absolute Return Bond Fund while the New Star Cautious Portfolio Unit Trust will go on offer from Monday.

The catalyst for the new wave of fund launches has been Ucits III – the third version of a set of Brussels regulations covering Undertakings for Collective Investment in Transferable securities – that took effect in early 2004, and the Financial Service Authority’s recent review of its rules for collective funds.

Ucits III allows a far wider range of assets to be included in a fund. Alongside shares and bonds, managers may now invest in cash, money market instruments, financial derivatives and units in other investment funds.

The FSA’s new book of rules, known as COLL, defines three types of funds: those created under the Ucits rules, which can be marketed throughout the EU; non-Ucits schemes that allow a wider range of asset classes but are only for the UK market; and qualified investment schemes intended for sophisticated investors.

“The challenge for us was to find new ways to add value in a consistent way in a low-yield environment,” says Quentin Fitzsimmons, manager of the Threadneedle Absolute Return Bond Fund. “We thought investors would appreciate a product that was less correlated with the fixed-income cycle.

“Ucits III allows us to use certain types of fixed income instruments that have in the past been regarded as unconventional but that allow us to achieve our investment aims with greater precision. We can hold cash as a long-term investment and not just as a management tool. We used to be restricted to using derivatives to hedge but now we can hold them as an investment in their own right.”

The Ucits III regulations have responded
to investors’ growing interest in a wider range of investment instruments – a few years ago most went no further than shares and bonds – and to the increasing diversity of portfolios.

The New Star Cautious Portfolio Unit Trust – a non-Ucits scheme – will also make use of a range of assets, says Mark Harris, head of the firm’s fund of funds team. “We can invest in UK commercial property, loan note funds and funds that invest in commodity futures. The great advantage of this is that we can use non-correlated assets which add protection to the portfolio.

“I won’t say we won’t encounter problems but we have the freedom and flexibility to cope with a lot of those things that with-
profits funds have struggled with.”

But in some respects, the complaints that investors had about with-profits funds have emerged in a different guise in the absolute return funds. Investors are used to seeing the top 10 “long” holdings in fund fact sheets but this information will be more difficult to provide on securities that have been sold short through derivatives, says Ilott. “Managers who use derivatives will want to avoid the risk that competitors might attempt to move the market in the opposite direction to the manager’s open position.”

And even funds that set out to smooth out market volatility should not be expected to perform well all the time, Ilott warns. “Investors should look to get the promised returns over a three-year cycle rather than expecting these funds to meet their targets each and every year.”