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How absolute return funds can help reduce risk

This article is part of
Guide to Absolute Return funds

How absolute return funds can help reduce risk

There are no guarantees with investment. While absolute return funds do aim to perform positively, regardless of the direction in which markets are heading, they do not guarantee returns.

Alex Hogan, press and digital media officer for the Investment Association, puts it this way: “The IA Targeted Absolute Return sector contains funds which aim to deliver positive returns in any market conditions.”

This won’t always mean an exceptional outperformance on the upside but the advantage is an aim of protection against the downside and diversification of risk.

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It also won’t always mean positive performance over a given time-frame. Some funds in the IA Targeted Absolute Return (Tar) sector currently are in negative territory over the past year according to data from FE Trustnet.

However, many of these funds are targeting a three-year positive return, not a one-year return; the numbers, therefore, do not always tell the whole picture when it comes to absolute return funds.

Diversification

Gavin Haynes, managing director of Bristol-based Whitechurch, states: “While they do not provide a guaranteed return, there are a number of funds within the IA Targeted Absolute Return (Tar) sector that have produced attractive risk-adjusted returns.

“The key advantage is they can provide added diversification to a portfolio invested alongside traditional asset classes.

“They can also reduce the cyclicality and volatility of a portfolio. At a time when investors are nervous over the traditionally lower-risk fixed asset class, some of the lower-risk funds in the Tar sector can provide an alternative for cautious investors.”

Absolute return fund managers aim to produce risk-adjusted returns by employing the flexibilities allowed to them since 2007, when the Ucits III regime came into force, to help manage the volatility.

Most funds use hedge fund-style strategies such as shorting, aiming to make a profit on a falling market or stock.

Fund managers can also use financial instruments such as contracts for difference to provide a limit on the downside, as a kind of insurance against the possibility that the company’s share price will fall.

To the extent that the short positions match long positions, the fund will generally be hedged (protected) against falls in the market, says Randal Goldsmith, senior analyst for Morningstar’s manager research team.

Spreading the money invested over a wide range of asset classes, investment strategies and financial instruments in this way can help reduce the risk of an absolute return fund and therefore of an investor’s overall portfolio.

Capital preservation

Furthermore, while diversifying to mitigate volatility, careful investment across a range of asset classes and geographies can provide steady long-term growth through capturing positive returns.

Adrian Lowcock, head of investing for Axa Wealth, says: “The advantage of these funds comes down to two main factors: capital preservation and diversification.” He determines these as follows: