FTAdviser.com

Advertising

Absolute return funds are supposed to supply returns whichever way the market moves. Designed to be able to short out-of-favour stocks as well as buy those on the way up, the extra flexibility should allow managers to post positive results whether the stock market is up or down.

At least that is the theory. In practice, however, the picture is a little cloudier, with many absolute return funds struggling to push past Libor plus 1 over 2007, and some even posting negative results.

One of the more successful funds, BlackRock's £630m UK Absolute Alpha, managed by Mark Lyttleton, is up by 10.68 per cent since the turbulence hit at the beginning of July last year. This compares with a fall by the FTSE100 of 11.64 per cent, and 11.92 per cent by the FTSE350.

The point is simple: even when the main markets went down, investors in Mr Lyttleton's fund still made money.

But not all managers are as skilled as he is. IFAs have started to question whether absolute return funds actually are delivering on their claims. "In the current climate, we will start to talk about absolute returns a lot less," points out Mark Loydall, director of Loughborough-based IFA Cambourne Financial Planning. "People are still hoping to achieve positive absolute returns, but whether they do or not is another matter."

For example, while it still posted positive returns, ABN Amro's ARBF V300 fund was up by just 2.93 per cent over the period from 1 July.

"We hold our hands up and admit we have not delivered over the last six months," admits Dan James, nominated chief investment officer for absolute returns at Fortis Investments. "But to be that microscopic in terms of timescale is not a fair way to view the asset class. You have got to look at how it sits in your overall portfolio and see what you are using it for."

Mr James's point about diversification is a fair one: in times of market turbulence it is best to spread your funds over many different asset classes. But the key point is whether or not absolute returns funds are living up to their claims.

"Absolute returns is the holy grail of investing," explains Kate Hollis, director of fund research and lead analyst on absolute returns funds at Standard & Poor's. "It is what every investor wants - to make money in any condition."

With the advent of Ucits III, funds now have the ability to short market risk, she continues, "and in a market that is going down rapidly, if you can be short the market you have the chance to make a decent amount of money".

Fixed income v equity funds

Ms Hollis sees a clear separation within the category between those fixed income strategies and equity funds.

"Fixed income managers have used derivatives longer and more often than equity managers," she says. "And under Ucits III you can only use derivatives to be net short, which means the greatest number of absolute returns funds come out of the fixed income process."

"However, these are the ones that have not done well," Ms Hollis continues. In essence, they are suffering from a structural problem, not the fact the markets are falling. "It is a lot harder to do well in semi-liquid markets. It has been very difficult in the last couple of months because all the fixed income funds have been struggling. You cannot say just because the majority of absolute return funds have come from fixed income and are currently struggling that they do not work."

"When these types of funds were launched people were happy to clip the coupon and build a position in corporate bonds," adds Quentin Fitzsimmons, head of government bonds at Threadneedle Investments, which offers a £39m Absolute Return Bond fund. "The managers just took the coupons and underestimated the risk of these strategies, and they have been proven to be far riskier than history had suggested. A lot of absolute return funds, especially in the fixed income space, have suffered badly."

ABN Amro's Mr James agrees. "One of the lags we are suffering is the illiquidity in the bond market," he says. "We are actively managing the bond positions we still believe in with a series of hedges to reduce market volatility.

"One of the benefits of the flexibility of the product is it helps us to minimise the volatility without having to lock in any potential losses."

This is particularly key in the credit markets, which suffers from asymmetric risk between the potential losses - usually greater - and the possible gains - much lower. Managers have been able to use derivatives to reverse the process to the benefit of the investor.

In September, ABN Amro launched another absolute returns vehicle, ARBF V150. "It has no exposure to credit, so it has done well - proving there is a case for absolute returns," explains Mr James. In addition, all the absolute return funds dependent on fixed income strategies will become very attractive once we have reached the bottom of the interest rate cycle," he adds.

The problem, of course, is not only have many of these funds not yet posted two or three-year track records, but they were also launched into very difficult markets. Yet this surely should be the time when they come into their own, argues Ana Cukic, co-head of the multi-asset group at Insight Investment. Her point is these funds are designed to limit the downside in times of trouble.

"You must look to hold a portfolio of uncorrelated assets," she explains. "It just means you can get in and out of an asset class if things go wrong." Aiming to provide cash plus 4 per cent after fees, the Insight Diversified Target Return fund has followed the market movements - down 1.5 per cent in January, but up again by 1.6 per cent in February, according to Ms Cukic. "A fund like ours is meeting its promises," she says. "We believe there are many different opportunities to take profits in different markets."

Choices

Ultimately, as in any investment, choosing the right manager and the investment process is paramount. "It is far too much to expect the manager to make the right decisions all the time," Ms Cukic points out. "Some of them have undoubtedly not been making the right decisions, particularly in the fixed interest market. The only ability for absolute returns funds to make their Libor plus 1, 2 or 3 in every market is predicated on the simple assumption the manager is going to make the right decision."

"An absolute return product needs to be well tuned to the environment," adds Threadneedle's Mr Fitzsimmons. "You need to trust the fund manager to put in strategies that may not pay off that day or the day after, but over 18 months to two years. We all want to get it right every day."

The US has had far more experience of absolute return funds, and the UK investor is understandably wary of a new strategy that so far has yet to produce the numbers to back up its claims.

"Some people have also been buying it for the wrong reasons," adds Mr James. "It is an asset class that is here to stay for a long, long time."

For Mr Fitzsimmons it is a question of making sure the investor feels comfortable with the asset class. "There is a degree of education that has to be done," he argues. "When we have introduced people to our funds we have been at pains to take them through these strategies, which represent a very rich seam for the currency and fixed income markets, which is maybe what the normal investor is unable to perceive.

"Ultimately, using this type of structure and investment approach is a very rational way to play between the bond markets."

Hugo Greenhalgh is editor of Investment Adviser