Absolute return funds: David Crawford

Understandably, this is an attractive proposition for investors in the current climate, who are seeking protection from continued market volatility.

Absolute return funds were launched by fund management groups following new regulations giving retail funds the power to use financial derivatives (contracts, rather than assets, with values based on the underlying security). Absolute Return funds were launched by fund management groups in 2007 following the introduction of regulations giving retail funds the power to use financial derivatives (contracts, rather than assets, with values based on the underlying security). The IMA (Investment Management Association) launched the Absolute Return Fund sector in 2008 to house these funds. The new regulations have ensured that these funds are operating within constraints that protect investors. They have since become a prominent feature of the investment world.

Previously, hedge funds, which like absolute return funds, aim for positive returns in all market conditions, operated for several decades as unregulated offshore vehicles. Investment in hedge funds carried a high level of risk as they did not operate with any risk constraints and were often geared, with high levels of debt. In the wake of the financial crisis, some hedge funds failed to meet their aims for investors, with performance dropping as the markets fell. In contrast, the new regulated absolute return funds operate with specific risk constraints imposed by the FSA, plus their own individual risk measures. Furthermore, they are not geared.

To understand how equity funds can work to deliver for investors over the long term, it is useful to consider the nature of the market cycle. Historically, economies move in boom and bust cycles. This is reflected and amplified by the market cycles of ‘bull’ (a rising market) and ‘bear’ (a falling market). Many regulated Absolute Return funds, some of which are equity funds, have only been in existence since the launch of the Absolute Return sector, only operating in a falling or ‘bear’ market so far.

Unlike more traditional investment vehicles, Absolute Return equity funds have the potential to deliver for investors in both bull and bear markets, because of the variety of investment strategies that they are able to employ. Fund managers can take both short and long positions, allowing funds to benefit from share price falls as well as rises.

The variety of investment strategies that these funds can use serves them throughout the market cycle. Within each stage of the cycle, there is a performance narrative for these funds which corresponds to the beginning, middle and end of that cycle. In a bear market, as economic contraction drives down share values, these funds will tend to adopt an overall short position. At the beginning of a bear market, fund managers can really capitalise on their ability to benefit from share price falls. Thus investors can expect the highest outperformance of long-only equity funds at this stage in the life of their investment. At the end of the cycle, as the market starts to shift, performance can be expected to become equitable to typical long-only equity funds.