Communicating the risks and rewards to clients

It is true while most absolute return funds try to always produce a positive return, or a return greater than that of cash or a select group of peers, some have made a loss over one and three years gross of fees.

A fund which has beaten its peers yet is still in negative territory, may well be a great fund, run by an experienced and excellent manager - but try telling this to a naive client or a prospective client who is new to investing.

All they see is the ‘minus’ sign in front of the performance figure, and when costs are added into the mix, the outcome seems less than stellar.

Indeed, as Gina Miller, founding partner of the SCM Group, puts it: “The name gives the perception of security and implies these funds will give positive returns in all environments, but this is very unlikely to be the case.”

So while the word ‘absolute investment’ may seem to indicate a fund will always absolutely outperform, it is important for the adviser to explain what absolute return funds are, what they aim to do - and what ‘performance’ really means in terms of diversification of risk and capital preservation.

Not doing so could land the client with an inappropriate fund and the adviser in hot water with the regulator.

In the Financial Services Authority’s 2012 Retail Conduct Risk Outlook, it listed absolute return funds as a potential concern.

It categorised them under a heading of “complexity in retail investment products and services”.

At the time, the regulator said: “Complexity does not necessarily imply higher risk, but we are concerned complex products are more likely to be mis-sold because they provide a greater opportunity to exploit consumers’ comparatively limited knowledge or understanding of risk.”

It broke out its concerns into four main categories:

• Consumers may not understand Absolute Return Funds (ARFs). For example, consumers may believe there is an element of capital protection, or guarantee of a positive return.

• Consumers could suffer significant unexpected financial loss if they are sold funds that fail to perform, and where the perception mentioned above continues to exist.

• The complex strategies and structures employed in ARFs could be more difficult to understand than those found in traditional long-only funds, and raise questions about their suitability for all types of retail investors.

• Financial advisers may not fully understand these products, which increases the possibility that poor communication of investment risks contribute to mis-selling to consumers.

This does not mean investors should not hold such funds as part of a well-diversified portfolio, providing the risks are explained Gavin Haynes

Tools

As Randal Goldsmith, senior analyst for Morningstar’s manager research team, explains advisers do need to heed the regulator’s warning against potential mis-selling of absolute return funds.

He says: “Advisers need to understand the mandate of whatever absolute return fund they are recommending.”

However there are things which can help advisers get an idea of what each fund is about.

The fund factsheet is just one. Mr Goldsmith explains: “The fund’s factsheets can give a quick idea of the fund’s investment scope, its approach to net market exposure (which can indicate the degree to which its returns will be affected by market corrections) and gross positioning (to indicate the potential for volatility).

“If the adviser cannot find these on the factsheet, he or she will need to dig deeper.”

Ratings agencies can help provide research on the various strategies and portfolio exposures, but further communication with the fund manager or someone in the group may be needed.

Also, the IA has created a tool to help filter funds in its TAR sector, based on a variety of criteria.

According to Alex Hogan, press and digital media officer for the IA, this tool offers “a starting point for those considering investing in funds in the TAR sector”.

However, each fund must be considered on its own merits as “comparisons across the whole sector are inappropriate”, Mr Hogan adds.

Gavin Haynes, managing director of Whitechurch, points to independent ratings on some of these funds from software provider Distribution Technology, which he says “could be helpful”.

Communication

The issue is how to communicate what these funds do, what they aim to do, and how they do it, to investors in a way that is clear and comprehensive, without blinding them by science.

As Mr Haynes says: “They do require more research and are more complicated than long-only strategies.

“If advisers are not confident in their understanding of the fund, they should not recommend it.”

According to Mr Haynes: “An adviser needs to understand and be able to explain the risk metrics of each fund, such as drawdown and volatility.

“It is going to be difficult for most clients to have a detailed understanding of the underlying working of an absolute return fund but this does not mean they should not hold such funds as part of a well-diversified portfolio, providing the risks are explained.”

Making the risks clear is crucial, as Adrian Lowcock, head of investing for Axa Wealth, confirms: “Ideally the use of an absolute return fund would be explained as part of the role within the wider portfolio and its suitability in respect of the investor’s objectives.

“I would also explain the strategy of the fund but refer this to examples where there is the potential to lose money.

“These funds are still vulnerable to sharp movements and losses - the key is how it diversifies and what the fund’s role is within an overall portfolio.”