When it’s time to play it safe

When it’s time to play it safe

We are facing a period of economic and financial uncertainty. Equity markets have bounced back following initial falls after the EU referendum, but we can still expect high levels of volatility – and further falls from here would not surprise many people.

While most investors should retain equity allocations in their portfolios, they may need to give serious thought to capital protection as well. However, many fixed interest investments look expensive, commercial property fund managers have suspended trading and cash rates are at historically low levels.

There are 93 funds in the Investment Association’s Targeted Absolute Return sector. It can be difficult to directly compare these funds as they can take hugely different approaches to achieve their goals. However, the objectives of many of the funds are broadly similar, whether that is a target return or achieving positive returns in all environments.

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From an investor’s perspective, they are not looking for these funds to ‘shoot the lights out’. Instead they want protection. They are looking for funds that will plod along and beat the returns on cash regardless of what is happening elsewhere. This is not always what they have got.

Many absolute return funds are highly correlated to stock markets, so when markets fall they lose value; not to the same degree, but then they do not capture all of the upside either. It is difficult to generalise too much because of the wide range of funds in the sector. However, those looking at absolute return funds to provide capital protection should look closely at their correlation with equity markets.@Image-99d9542e-d638-456f-8ccd-bd6d71c075bc@

Another concern is the level of charges. It is understandable that ongoing charges on these funds are slightly higher than on conventional long-only funds. However, for products that are often trying to generate just a few percentage points of return, it is difficult to justify some of the performance fees charged.

Often these performance fees are hidden in the small print of fund managers’ documents. Based on online research, it is fair to say that many investment companies are not particularly forthcoming in telling people that they impose performance fees and then how they actually work.

The good news on performance fees is that funds usually adopt a high water mark. This at least means managers cannot impose extra fees after a short turnaround following significant negative performance.

However, that is about where the good news ends. Performance fees are often charged at 20 per cent of outperformance for beating a notional benchmark. That benchmark might, for example, be Libor rates, which are currently about 0.5 per cent per annum. On this basis the performance of the Santander 123 bank account would be considered good enough to rack up some juicy performance fees.

If a fund manager is confident in their ability to out-perform and wants to apply performance fees, the fairest way is first to reduce the ongoing annual charge and, second, to introduce a meaningful performance hurdle. Funnily enough, managers do not seem particularly keen to do this,