Funds that should be absolutely fabulous can offer poor returns

Investors are fleeing from the much-criticised absolutereturns sector, but there are winning funds.

Absolute return funds aim to provide positive returns regardless of market conditions. So with the recent heavy volatility in stock markets, they should be hugely popular. Yet this week the Investment Management Association reported the sector has just had its worst month on record.

The IMA records the amount of money invested in or taken out of different sectors. It says absolute return funds had £122m taken out in August, the worst monthly outflow since the formation of the sector in April 2008.

Yet the performance figures show that the sector, on average, is doing its job. Over the last 12 months, when markets were generally on the rise, the sector is 22nd out of 33 IMA sectors. But in August, when markets fell, absolute return funds proved to be the fifth best sector to be in, albeit posting an average 1.5 per cent loss.

In contrast, the top performing sector over a year was UK Smaller companies with a 17.6 per cent increase. But in August it was the second-worst performing sector with a fall of 10.1 per cent. In short, absolute return funds reduce the volatility. So why are they now beginning to prove unpopular?

Part of the problem is the cost, says Adrian Lowcock, senior investment adviser at Bestinvest. "Simply put, many of these funds are not worth the costs," he says. "They have additional performance fees onto top of the annual management charge which is in itself a performance fee in that if the fund grows the charge grows."

Chase De Vere's Patrick Connolly also mentions the cost, but says the poor performance of many absolute return funds is also a worry. "The high fees include performance fees of typically 15 or 20 per cent for beating a notional benchmark, such as UK base rates or Libor rates. With them standing at considerably less than 1 per cent per annum, at the moment, the performance of many bank or building society accounts would qualify for a performance fee."

He points out that in the past three months only 20 out of 62 funds in the sector have made a positive return, and over six months just 24 out of 60. Over both periods the average fund has fallen in value and the worst have fallen more than 13 per cent.

"Many investors in absolute return funds don't understand what they have bought. The name absolute return gives the perception of security and implies that funds can give positive returns in all environments when the performance figures show the reality is somewhat different."

There has been criticism of the name 'absolute returns' as misleading and there were hopes this year the Investment Management Association would change the sector title. But in its review of sectors in May it declined to scrap the term in favour of something that more adequately describes the wide range of different types of funds that are grouped under the heading.

That's not to say all absolute return funds are to be avoided. The key is to understand exactly what you're investing in, what its aims are, and how it will achieve those aims.

"As with any type of fund, you get managers who are adept and those that disappoint. Absolute return is no different," says Ben Yearsley of advisers Hargreaves Lansdown.

"Personally I think some are worth the cost. They can provide a core to a portfolio and if they can deliver results of 7-8 per cent a year, I'd be more than happy. However I would suggest owning a range of them."

Christopher Peel, a partner at absolute return fund provider Blacksquare Capital, says successful funds must achieve their clearly defined investment objective and policy and fulfil the IMA Sector definition of an absolute return fund. If so, he believes they can come into their own.

"The vast majority of absolute return fund managers are capable of managing risk dynamically in changing market conditions," says Peel. "This is not to say they will not lose money on any given day, week, month, quarter or year, but evidence suggests that the industry consistently produces superior risk-adjusted returns when compared to the long-only market."

So which absolute return funds are worth considering? Those that achieve their aim should outperform in falling market conditions and generally underperform in rising markets. "As ever you are relying on the skill of the manager getting it right," says Ben Yearsley. "There are no magic black boxes guaranteeing a positive result."

"Careful selection is vital," says Brian Dennehy of Dennehy, Weller & Co. "Volatility, or lack of it, must be a criteria with absolute returns." He favours Absolute Insight which has climbed 19 per cent over three years. "But it's not perfect," he warns, "none of them are."

Adrian Lowcock picks the Standard Life Global Absolute Return Strategies fund, which has returned 23 per cent over three years. Patrick Connolly mentions BlackRock UK Absolute Alpha, Newton Real Return and Schroder Absolute Return Bond, but has a warning for potential investors.

"Despite being in the same sector, these funds work in entirely different ways and so it is important for investors to understand exactly what they are buying and the likely returns they can expect," he says.

One thing we do know is that stock markets are likely to remain volatile. "So we expect continued demand for low-risk funds," says Connolly. "But we also expect many investors to be duped into paying higher fees for absolute return funds they don't really understand and for performance which may not live up to expectations."