Returns with little risk at a time like this?

As investor interest wanes in the face of falling stock markets and meagre savings rates, Julian Knight looks at the funds being marketed as an antidote

Even after 12 months during which share prices have fallen at an almost unprecedented rate, the fund management industry is still busy dreaming up ways to get investors to part with their cash. And the latest "must haves" are "absolute return" funds.

As the name suggests, these aim to give the investor a regular return above what is available through a cash savings account but with less risk than through a standard index- tracking unit trust or an actively managed fund, where the manager picks shares he or she thinks will perform well. How is this trick accomplished – the investment holy grail of returns with low-end risk?

"The idea is to give the standard retail investor access to a fund which uses many of the tools deployed by a hedge fund, without, crucially, the heavy borrowing that hedge funds do which makes them high risk," says Darius McDermott, the managing director of discount broker Chelsea Financial Services.

"Absolute return fund managers have numerous weapons they can deploy. They can buy and sell shares like a standard manager. They can short sell a stock which they think will fall in value in the future. Some mix shares with bonds and cash accounts too," he says. "By doing all this, the manager looks to break the link between moves in the underlying stock market index and fund performance."

And breaking the link with the underlying stock market has an obvious appeal in the current climate, where share prices have plunged as the world economy sinks into the mire.

With the 5 April deadline approaching for putting money in an individual savings account (ISA), and with investor interest in the stock market at near zero, the fund management industry is desperate to find something new and exciting to say amid all the doom and gloom. And as far as the marketing professionals, are concerned, the answer is absolute returns.

In the past few weeks, Gartmore, Ignis Argonaut and SVM have all launched funds in this category – a trend, according to Barry Norris, the manager of the Ignis Argonaut European Absolute Return fund, that reflects the tumultuous financial times we are living in. "This market is a once-in-a-generation cycle and the old models of simply buying some shares and holding on to them is not able to cope," he says. "The thing about absolute returns is that the manager has the freedom not only to buy stock he or she believes will outperform, but also to sell stock – through shorting – that is overvalued."

Across Europe, Mr Norris estimates, a quarter of stocks are undervalued, while up to half could be overvalued. In particular, he is bearish about mining and raw material stocks: "These have had massive growth over the past six years, but with the economic contraction a bit of bust is inevitable. All in all, across many sectors, there are lot of companies listed today which won't be around in a couple of years."

Generally, when fund managers talk about "freedom" to invest and short- selling stock, it equates to a high-risk strategy. But according to Adrian Lowcock from independent financial adviser Bestinvest, that isn't necessarily the case with absolute returns.

"It all sounds high risk, but remember that managers can use cash or bonds in order to hedge against stock market investment choices going awry," he says. "In some traditional unit trust funds, managers have to stay invested in their specific market no matter what is going on."

And Mr Lowcock adds that some absolute return managers are guided by the message that their funds should produce growth over the long term, without undue risk: "Look at Mark Lyttleton, the manager of Black Rock's Absolute Alpha fund. He takes the point that investors are using the fund to pay their kids' school fees or to finance their retirement seriously. In times like these, a manager with lots of freedom to act but with such a cautious outlook can be worthwhile."

But Mr Lowcock is a little more guarded in his approach to the absolute returns sector as a whole: "There is always a danger that investors get sucked into the latest craze. We have seen it before from technology funds through Russia.

"The difficulty is that the fund management industry spots a marketable idea and then rushes out a load of new funds, creating investor interest up until ISA deadline, but the funds aren't quite what they are cracked up to be and they underperform,

"This short-term attitude does a lot of damage to the industry as a whole as it turns off private investors," Mr Lowcock concludes.

In what has admittedly been a terrible year for stock markets, the longer- established absolute return funds have not pulled up any trees. Even Mr Lyttleton's much-vaunted Black Rock returned a negative performance of 1.7 per cent, according to financial information service Trustnet.

Some other funds have also had a difficult 12 months. The EFA Absolute Return Portfolio fund has lost 8.3 per cent of its value, for example.

However, funds in the sector as a whole have shrunk by around 2 per cent on average over the past year – and this has to be set against a drop of around 30 to 35 per cent in the British stock market as a whole during the same period, as the banking crisis and recession have deepened.

One fund, though, has bucked this trend with aplomb. The Threadneedle Absolute Return Bond has managed an eye-catching record of 11.1 per cent growth over the past year, and 24.1 per cent over the past three years. This is because it largely focuses on the bond market, which has fared far better than shares as companies, desperate to raise fresh capital, have paid bumper rates of return on the bonds they issue to investors.

Overall, Mr McDermott admits there are some "bad apples" in the absolute returns sector. "The problem is that some funds are simply too small and as a result they can't diversify their investments. And this means that they can't hedge their share picks as effectively as the bigger funds.

"There is another problem," he adds, "and that is if the stock market suddenly turns around and starts climbing again. Absolute return funds won't benefit from all of the upside then because they hedge.

"If I was picking an absolute return fund, I would go for managers and firms with a good track record in, say, the hedge fund field."

Mr McDermott at Chelsea Financial Services likes the look of the Cazenove UK Absolute Target fund and Legal & General's Diversified Absolute Return, which casts its net wide in a bid for performance. "As well as shares, the L&G fund looks at investing in currencies and bonds," he says.

Like Mr Lowcock, Mr McDermott is also a fan of the Black Rock Absolute Alpha fund.

But the complexity and much-heralded promise of absolute returns does not come cheap. Annual management fees are typically 1.5 per cent and if the fund excels, managers routinely look to claw back extra fees of around 20 per cent of any outperformance.

"Be careful how managers levy their charges," says Mr Norris at Ignis. "Sometimes outperformance can just mean that it beats the stock market in a year, but when it loses a third of its value, that isn't much of a benchmark."

Mr Norris's fund uses a fee structure called the "high watermark". In effect this means that an outperformance fee will only be triggered if the unit price of the fund reaches an all-time high.

What's more, although fund units can be bought across the sector for an initial investment as low as £500 to £1,000, the upfront charges on the funds stand at around the 5 per cent mark, which is high. However, if the investment is made through a finance supermarket such as Funds Network, Hargreaves Lansdown's Vantage or alternatively via an independent financial adviser, these fees can be cut to around zero.