Absolute return funds: Is this the best of all possible worlds?

A promise of profits without risk. Kate Hughes is slightly sceptical

For most of us, talk of economic downturns and recession means a flight to financial safety. We batten down the hatches while the storm rages around us. For investors, while this strategy means that they don't lose anything, they don't make anything either. So the possibility of making money in a falling market with little risk can be intoxicating.

Absolute return funds claim to offer this elusive prize: good performance for low risk in any kind of economic climate. They aim to make you money regardless of whether the markets rise or fall. But actually achieving this is a very tall order, and most absolute return funds have struggled to deliver.

SLOW AND STEADY?

Although they only burst on to the scene three years ago, thanks to a change in derivatives regulation, the variety of absolute return funds out there today is daunting. The goal of all of them, however, is the same: to make steady, positive returns, whether the markets are falling or rising.

Scottish Widows Investment Partnership's Absolute Return Bond Fund( www.swip.com/absolute_return) and Threadneedle's Absolute Return Bond Fund ( www.threadneedle.co.uk), for example, try to protect their funds by investing only in bonds and cash. They are far less volatile than their peers, but the performance enjoyed by their investors is also limited.

The Swip Absolute Return Bond Fund aims to deliver, over the long term, the equivalent of just 1.5 per cent per annum above the Bank of England base rate, after fees and taxes. "The fund aims to offer a low-risk strategy, using bonds and cash to produce positive absolute returns," says Craig Inches, manager of the Swip fund. "It is a fund for lower-risk investors looking for cash-level returns, but with exposure to bond markets."

He acknowledges that the returns aren't great compared to direct investment in equities, but says that investors must be realistic about the relationship between risk and reward. "Investors assume that equities provide higher returns," he says. "But they come with higher levels of risk. And if you have a bad year, it can be a very bad year." Over 10 years, he suggests, absolute bonds can offer returns that are "not that far away"from equities expectations, but with a small fraction of the risk.

Some absolute funds spread themselves across a huge range of asset classes in an attempt to reduce the effect of volatility in one sector or region. The more diversified your fund is (the thinking goes), the lower the risk – if one sector drops, you can fall back on others to minimise the loss. For example, the Mellon Global Absolute Intrepid fund, run by Newton ( www.newton.co.uk), has holdings in UK, US and Japanese equities, as well as fixed interest and cash. According to Mellon, the fund has returned 95.98 per cent over the past five years, against a sector average of 64.96 per cent.

HEDGING YOUR BETS

Other absolute funds employ more complex approaches in a bid to offer less risky returns to investors. In 2004, a regulation overhaul meant that regulated funds could use "short-selling" techniques, allowing funds to gain from drops in markets as well as rises.

Managers "short" the market by borrowing stock, selling it, and then buying it back once it falls. Funds that use this technique tend to have the most reliable performance, says Andrew Wilson, head of investments for the financial adviser Towry Law. "The manager has to be a good one, though, and BlackRock's UK Absolute Alpha Fund ( www.blackrock.co.uk), run by Mark Lyttleton, is one of the best," he says. Lyttleton's fund has returned 12.5 per cent over the past year, during which time the FTSE 100 has fallen more than 5 per cent.

Although the FSA won't allow managers to disclose information on their short positions because of the potential damage it could do to those companies, Lyttleton's top 10 long positions include easyJet, BAE Systems, and the Mediterranean property development company Dolphin Capital. BAE, for example, has seen its shares rise by more than 8 per cent over the past year, even as the markets have been falling.

DO THEY HAVE A PLACE IN YOUR PORTFOLIO?

In all their various guises, absolute return funds are aimed at cautious investors looking for low-risk funds to form the foundation of their portfolios, and investments can be made from as little as £50 per month. But the verdicts on most absolute funds have been far from positive.

"Absolute return funds have frankly been an embarrassment," Andrew Wilson warns. "They have almost uniformly failed to deliver – along with their close cousins, target return funds. They may have diminished risks, but they have almost entirely evaporated returns at the same time."

He also warns that assessing a fund's performance against others is virtually impossible because they are all so different. There is no absolute return sector like UK All Companies or Cautious Managed sectors, and absolute return funds are benchmarked against a variety of different sectors based on the underlying holdings. This makes it very difficult to determine decent performance because the funds are all measured against different yardsticks. And investing in absolute returns will usually match other, higher-yielding vehicles, often with an initial fee of 5 per cent and annual management charges of 1.5 per cent or more.

Meanwhile, investors are also expecting the best of both worlds when it comes to performance and risk, adds Philippa Gee of the financial adviser Torquil Clark. "Investors have become disillusioned by absolute return funds because of poor performance," she says. "But they don't make the connection between returns and risk. You can't have everything, but investors expect more than they are getting from absolute funds. They also assume an extra level of security which is not necessarily there."

"Investors just don't need these funds to protect themselves from volatility in the markets," says Wilson. "By using the correct asset allocation, investors can manage their investments in difficult periods without resorting to absolute return funds."

"Those who are concerned about the effect of a downturn in the economy and a bumpy rise for the markets should put 30-40 per cent of their investments in cash, and then look at spreading their investments in equities," adds Gee. "The golden rule is not to invest in a name or trend, but to invest in what is right for you as an individual."

The experts' favourite absolute return funds

"Investors become fixated on positive returns when stock markets are falling around their ears," says Keith Thompson of financial advisers Blackadder. "Absolute return funds fill a niche in the private investor marketplace. Providing that investors understand their limitations, these funds can give peace of mind that they should provide steady, consistent, positive returns for the cautious investor (as long as the fund manager delivers). Absolute return funds sound like the ideal solution, but these funds are likely to underperform a rapidly rising market."

He notes that the majority of managers have not met their fund objectives over the last year, and he urges investors to choose carefully. "I prefer the BlackRock UK Absolute Alpha, Insight Diversified Target Return, SWIP's Absolute Return Bond and the Arch Cru Income Portfolio funds," he says. "I use each fund in different proportions to cover a wide range of asset classes.

"But the success of these funds is highly dependent on the fund manager's skill. In fact, this may be one asset class where investors would do well to follow the fund manager in the future rather than the fund itself."

John Davey, a research analyst for the investment adviser Bestinvest, also recommends the BlackRock UK Absolute Alpha fund, and adds Dexion Trading, a "macro" hedge fund, so-called because it aims to profit from changes in global economies. "The volatile environment we are currently seeing should benefit macro managers, who have the biggest arsenal of markets and instruments to trade," he says.

He says that Thames River Hedge + is worth considering too. Though one is always warned that past performance is not an indicator of future success, he notes that "the fund's performance over the last year has been strong, and was driven by three of the underlying managers being short of sub-prime."