Can you trust fund managers who promise to hit the bullseye?

A fund that aims for a specific return is tempting. But it's not for everyone, warns James Daley

Investor confidence is still bruised after the savage equity bear market between 2000 and 2003, and the financial services industry has been racking its brains to find ways of luring people back from the safety of instant access savings accounts. Having watched the value of their investments plummet between 2000 and 2003, many investors are still unwilling to commit their money to the stock market again - or even to fixed-interest assets such as bonds. But, with interest rates sitting below their long-term average - even the best accounts pay just 5 per cent a year and rates are now falling - many savers need to find some way of improving returns.

Enter a new type of investment fund - so called "target return funds". Although the half-dozen or so funds launched so far vary, the common thread is that they all aim to provide a specific annual return that betters the Bank of England's base rate.

This is a deliberate move away from the traditional idea of benchmarking a fund to an index - where a fund manager tries to better his rivals and the average performance of the market in which he invests. The problem with the latter approach is that it doesn't guarantee positive returns.

For instance, the best-performing technology and telecoms fund over the past five years - Artemis New Enterprises - has outperformed its benchmark by an enormous 50 percentage points, and has won several awards. However, it has still lost investors more than 16 per cent of their initial investment over that period.

After this sort of experience, many investors simply want a product which provides a better return than the bank or building society savings account, but which does not put their capital at much, if any, risk. Traditionally, this might have been a with-profits fund, where volatility is levelled out over time, but the collapse of with-profits endowments has soured perceptions of these plans.

"I think everyone is still looking for a replacement for with-profits," says Ben Yearsley, an investment manager at Hargreaves Lansdown, the Bristol-based financial adviser. "I also think investors are a lot more aware of the downside risk than they ever were."

With-profits funds were designed to smooth investor returns - limiting the payouts when markets were good but also, and more importantly, limiting the downside when markets were falling. These have fallen out of favour in recent years after many funds were forced to slash payouts because their managers had under-reserved when markets were strong.

But can target return funds really be a replacement? The majority of funds aim to outperform the Bank of England's base rate, or Libor (the rate that banks charge each other to borrow money over a set period) by between 2 and 4 per cent a year.

The Target Return Fund from Credit Suisse Asset Management (CSAM) was one of the first into the market when it launched in April 2004. It aims to pay 2.5 per cent above Libor. Similarly, Old Mutual's offering - the Prosper 80 fund - aims to pay 4 per cent above base rate.

However, each fund's target is worth a closer look. CSAM's rate sounds reasonable, but closer inspection reveals that the 2.5 per cent target is before annual charges of 1.25 per cent a year have been taken into account - and although the fund invests in low-risk fixed interest securities, it comes with no capital guarantee.

Toby Hogbin, the head of product management for CSAM, argues that his fund is genuinely low risk. He says its modest return should end up being much more substantial over the long term. "One per cent over Libor may not sound immediately attractive," he says, "but if you compound that over 20 or 30 years in a pension fund, then it becomes material."

Old Mutual's target of 4 per cent above base rate is after charges, and comes with a pledge that your investment can never fall more than 20 per cent in any six-month period. This fund, however, invests in a series of hedge funds, which have the potential to be much more risky.

However, if the fund is true to its mandate and sticks to a handful of different hedging strategies, then it is more likely to meet its annual target than many of its competitors.

Another variation on the theme is DWS Investment's Ratebuster fund. This uses a principle that is much easier to understand - the managers work out how much interest they will earn in a cash-based account over one year, and hold a portfolio of derivatives. It aims for a target of 3 per cent above base rate - after charges - and guarantees that you won't lose any of your initial investment.

David Chellew, a senior products manager for DWS, says: "If an investor wants capital security, we find that they tend to want total security, not security dependent on a number of factors. We admit that we're taking a significant amount of risk with your interest - it's perfectly feasible that we could lose it all over a six-month period. But investors can't lose any more than that."

While DWS is relatively open about the risk of its funds, most of the market's other providers are eager to play the dangers down. Although CSAM's fund has very modest targets, which only just beat the building society, it missed these spectacularly in the fund's first year - losing investors more than 1.5 per cent after charges. Hogbin says he is confident the company will achieve its annual targets over each three- to five-year market cycle. However, the start was not impressive.

Target return funds may be suitable for a small number of people who may want to take a small step before jumping back into anything higher risk than cash, but most investors may want to think twice.

Many of these funds are simply bond, or distribution, funds by another name. And, while products such as Old Mutual's are genuinely innovative, it may be worth giving the fund managers some time to prove they can do what they say before you commit to a product such as this.

Yearsley concludes: "If you can produce 7 or 8 per cent returns, year in year out, while interest rates are at 4 per cent - then that's an amazing product. The question is - can they actually deliver?"

To find a financial adviser in your area, go to www.unbiased.co.uk

Not to be confused with...

* A number of so-called "target return" funds have sprung up in the past year. However, a forerunner to these - and based on a very different concept - were Fidelity's "Wealthbuilder Target Funds".

* These are, in fact, a series of funds of funds, which invest in a mix of equities, bonds and cash, and work towards a pre-specified maturity date, to aid financial planning.

* For example, the Fidelity Wealthbuilder Target 2020 fund currently invests about 95 per cent of its portfolio into UK and overseas equity funds, and about 5 per cent in bonds.

* As the fund gets closer to maturity, its asset allocation changes, with the proportion in equities reducing and bonds and cash increasing.

* By the time the fund comes into its final months in 2020, it will have about 10 per cent in equities, 50 per cent in bonds and 40 per cent cash, ensuring that risk is reduced as the fund nears maturity, to help protect the lump sum.

* Its only similarity with "Target Return" funds? The name.