Your IndustryMay 12 2016

Are absolute return funds too expensive?

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Are absolute return funds too expensive?

Investors who are careful about costs may think twice before opting for an actively managed fund instead of a passive strategy or even a smart beta style fund.

Most absolute return funds have slightly higher annual management charges (AMCs) or ongoing fund charges (OFCs) than passive investment funds, because of the active management of the holdings within the fund.

According to research from consumer champion Which?, although the average AMC is approximately 0.75 per cent for most funds, additional costs can add at least another 0.1 per cent on top of that, taking the OCF to an average of 0.85 per cent.

But within this average lies a range of funds, from cheap passive index trackers, which can be as low as 0.1 per cent AMC, through to higher-octane actively managed funds.

So if a fund manager carries out an annual turnover rate of 100 per cent in the portfolio, or uses financial instruments to mitigate the downside, your clients could face an additional 1.8 per cent cost on top of the 0.85 per cent OCF.

Investors need to be aware the lack of a high watermark and low hurdle rate can reward the manager at the expense of the investor. Randal Goldsmith

However, not all fund management groups pass on high costs to the end investor and some absolute return funds could end up being lower cost than the 75 basis points standard.

James Crossley, head of retail distribution for Jupiter Fund Management, says: “As an example, our absolute return fund is priced at 0.625 per cent AMC, compared to general equity funds as standard at 0.75 per cent.”

Randal Goldsmith, senior analyst on the manager research team for Morningstar, says: “Absolute return funds are not all significantly more expensive than ordinary funds.

“However, financing costs increase with the use of gross leverage and application of shorts, and these will likely be passed onto the investor, but are generally justified.”

Moreover, some absolute return funds, which may have set their managers particular performance targets, have historically added a hurdle fee of up to 20 per cent on top to reward significant outperformance.

Mr Goldsmith adds: “Some absolute return funds have performance fees and where these are not matched by commensurately lower fixed AMCs, the justification is less clear.

“Investors need to be aware the lack of a high watermark and low hurdle rate can reward the manager at the expense of the investor. The absence of a high watermark can also encourage a manager to take unwarranted risk because past poor performance does not have to be made up for.”

Post-Retail Distribution Review in 2012, and after new guidelines introduced by the Financial Conduct Authority in May 2014, fund charges have become more transparent, which in turn has seen some funds get cheaper.

Clarity of fund charges: FCA’s expectations

1. Firms have a duty to act in the best interest of investors. This means all firms must ensure their charges are clear to investors, particularly retail investors, so they know what they are paying for and can compare funds.

2. Communications with retail customers should be fair, clear and not misleading for both Ucits and non-Ucits funds.

3. For Ucits funds, information on charges in marketing material (including websites) must be presented to investors in a way is consistent with the key investor information document (KIID).

This means using the OCF as the headline charges figure.

4. Platforms, advisers and other intermediaries should also use the OCF as the headline charges figure for Ucits funds.

5. Descriptions of charges in the prospectus should explain clearly how the charges work.

But it is not easy for the average investor to see immediately whether some funds have seen a performance fee levied, what is or is not included in the OCF, and at what point a performance fee will be triggered.

Adrian Lowcock, head of investing for Axa Wealth, says this lack of clarity and higher expense has hurt the absolute return sector in recent years.

But he adds the situation with absolute return fund charges is improving.

Effect of cost on returns

He says: “Some funds do require greater resource but the sector has suffered from excessive charges with additional outperformance fees and horrible additional charges when they make additional return.

“Given how much charges can erode the value of investments, this excessive charging has been reined in and is improving.”

Key pieces of European legislation have been implemented or are being implemented, such as the regulation on key information documents for packaged retail and insurance-based investment products (Priips), and the revised Markets in Financial Instruments Directive (Mifid II).

Both regulations will change the way information is provided to investors at the point of sale.

Regardless of transparency, some fund managers believe a portfolio of passives can outperform a straight absolute return fund. Gina Miller, founding partner of SCM Private, says: “Over the past five years, the average Investment Association (IA) Targeted Absolute Return fund has risen by 12.65 - that’s 2.4 per cent a year.

“We have shown year after year, a portfolio of actively managed exchange-traded funds can knock the socks off an absolute return fund at a fraction of the cost.”

The SCM Absolute Return Portfolio has a total investment cost, dealing and management included, of 0.91 per cent and has returned 21.9 per cent over the last five years (gross of fees), as at 31 March 2016.

“The central problem of many absolute return funds”, Ms Miller adds, “is in their desire to dampen volatility, they have practically extinguished the returns. A market of low returns, when combined with excessive fees, yields little to investors.”

But not all industry commentators think the additional expense is unnecessary - some believe the higher potential returns and greater downside protection outweigh the cost.

This is because absolute return funds are the “epitome of active management” and therefore higher management costs are to be expected, according to Gavin Haynes, managing director of Whitechurch.

Mr Haynes says: “On the whole, they are broadly in line with actively managed funds.

“It would be cheaper to use passive options, but by their nature these track markets, while the objective of most absolute return funds is to generate a positive return irrespective of market direction.”