At first glance, absolute return funds – which aim to earn positive returns in rising and falling markets – appear to be a superior choice compared with funds of hedge funds.
Their appeal is that they tend to offer smoother returns and can be sold more easily. They also fall under the European Union’s Ucits III directive, which gives mutual fund managers the power to use derivatives to generate higher returns, rather than simply to reduce risk.
The pick-up in interest for the 25 to 30 listed funds in the sector is not likely to slow. Cazenove’s Absolute UK Dynamic Fund hit its target of £99m on the day of its launch last month, for example.
Such demand has encouraged fund houses to add more absolute return funds to their staples and recruit hedge fund managers to run them. Tim Russell is at the helm of Cazenove’s UK Absolute Target return fund as well as its hedge fund, for example, and Roger Guy manages Gartmore’s hedge fund and absolute return fund as well.
Another upside is that current market conditions throw up a sweet spot for long-short strategies. Defensive sectors such as pharmaceuticals and utilities look cheap compared with cyclicals, offering the chance to take long positions in the former and short the latter.
And the gearing levels of absolute return funds have risen sharply recently, a reflection of managers’ renewed interest in leverage, according to Mick Gilligan, head of research at Killik and Co, the advisers.
“I’m quite positive on absolute return funds at the moment because it’s so difficult to call the direction of the market,” says Gilligan.
Buying into absolute return funds offers some protection if the current market rally reverses. “There is concern that the rally is not sustainable and funds that can short may be well-placed in the event of a correction,” says Tim Cockerill, head of research with the advisory firm Rowan.
However, advisers say that, in many cases, it is unfair to compare the performance of absolute return funds with long-only funds as many will never achieve the same upside if shares climb higher.
One drawback of absolute return funds is the fees. In some cases, hedge-fund style fees – which can be as high as 2 per cent for management and 20 per cent for performance – are being applied for exceeding returns over cash.
On top of an initial fee of 5 per cent, BlackRock’s UK Absolute Alpha fund has an annual management charge of 1.5 per cent plus a 20 per cent quarterly performance fee if returns over a set period exceed three-month sterling-based Libor (the interbank lending rate), which this week hovered at just 0.6 per cent.
Cazenove’s UK Absolute Target fund, managed by Tim Russell, also levies a 5 per cent initial charge, along with a 1.25 per cent yearly management fee and a 20 per cent fee if the fund’s net asset value (NAV) exceeds the highest NAV seen at the end of all previous quarters when shares are cashed in.
These funds’ total expense ratios – estimated to be about 4 per cent per year on average – are so costly that some advisers warn investors against buying in. “Active management is a loser’s game and must, by definition, underperform the market as a whole,” says Jason Butler, a financial planner at Bloomsbury.
But, in most cases, absolute return funds appear a safer bet than listed funds of hedge funds, which are “relatively illiquid” and far more volatile, claims Richard Skelt, manager of Fidelity’s Wealthbuilder fund.
Memories of the market downturn are still vivid and while the discounts of share prices to NAVs have narrowed to an average range of 13 to 15 per cent, long-term investors remain sceptical of these investments.
“From an investor’s perspective, they are no longer a gravity-defying option,” says Cockerill of Rowan.