Smoothly does it with absolute return funds

These investment vehicles promise positive growth in bear as well as bull markets, but is it all too good to be true? Julian Knight investigates

For some, absolute return funds are an investment no-brainer; for others, they're nothing more than marketing flimflam. The argument for absolute return funds is a relatively straightforward one to make.

These funds, deploying many of the same investment tools – such as futures – used by hedge funds, aim to provide a regular return above what is available through a cash savings account, but with less risk than a standard stock market fund.

"The idea is to smooth out returns over the long term. You don't get years where you see 30 or 40 per cent growth or loss. Instead the idea is to produce steady returns comfortably above what can be achieved through a cash savings account," said Ben Yearsley from independent financial advisers Hargreaves Lansdown.

"If most investors were asked if they would like a fund which is geared to providing 7, 8 or 9 per cent growth year in year out, they would be delighted, particularly when you consider that a fund which mirrored the performance of the FTSE over the past 10 years would actually have lost you money," Mr Yearsley said.

Instead of just buying and holding shares that the fund manager thinks will increase in value, an absolute return manager is able to take positions which will make the fund money if a particular share actually falls in value. In addition, managers can invest in a mix of shares, bonds or cash accounts all with the aim of giving a smoothed return to the investor. Freedom for the fund manager is the name of the game but within the confines of a target to deliver an absolute return not just long term but every year.

Great selling point in a bear market, but in 2009 the UK stock market, against many analysts' initial forecasts, rose substantially. So far in 2010, there are few signs of the bull market abating. "It is difficult to say to an investor go for absolute return funds which can rise, say, 10 per cent when you see the stock market as a whole rising by a quarter in a year. Nevertheless I'm still a big fan," said Mr Yearsley.

However, David Kuo, a director of investment website Fool.co.uk, sees this as a bad time to be moving into absolute returns. "Sure there are some well-managed absolute returns funds out there but there are some poorly managed ones too. The truth is, though, that in this market just about any fund could make you money, so why go for the complexity and expense of absolute returns?"

But for Barry Norris, who manages the Ignis Argonaut European Absolute Return fund – as well a standard unit trust fund – the idea is to take the element of market timing out of the equation.

"With a standard unit trust you look to buy at a time when you believe the stock market it operates in will rise in value. Be successful and you make money, but if the stock market tanks then standard unit trusts are very likely to follow the index down. It is possible with a standard unit trust to have had a good year if it loses 10 per cent as against a 20 per cent loss in the overall stock market.

"The aims of an absolute return fund is very different and it's flexible enough to make money in a falling market. Absolute returns tend to give up some growth on the upside, but when the markets fall you should still be able to make money. Managers are in effect not measured against the performance of the overall stock market, but in the simplest terms do I make my investors enough money?"

Absolute returns is a relatively new investment sector: there are only six funds that have a track record of more than three years and new launches are occurring regularly. In many respects, it's still too early to tell if the claims made for absolute returns actually hold water, although some try. "Over three years, unit trusts invested in the UK stock market are down 10 per cent while absolute return funds are up 13 per cent," said Gordon Davidson, the managing director of Jupiter Asset Management Unit Trusts which has recently launched its absolute returns fund managed run by the hedge fund star Philip Gibbs.

"Philip Gibbs has produced a positive return for his investors every year since 2000. These funds are pretty sophisticated compared to a standard unit trust, and I think investors should look for managers who have a track record of successfully using the same investment tools – such as future contracts – which are available to hedge fund managers. This is where we think Philip comes in," Mr Davidson said.

But investors need to be aware that not all absolute return funds carry the same degree of risk. Some managers, it seems, are willing to take greater investment gambles in order to produce a healthier absolute return.

"This is a rapidly expanding sector with funds being launched regularly but it's far from homogeneous," said Mr Yearsley. "You could divide the sector into three: low, medium and higher risk. In short, a manager of a lower absolute returns fund will take fewer risks because they don't want to record a loss, whereas a higher-risk manager will take more chances trying to outperform the other absolute return funds. The Philip Gibbs fund is one of these higher-risk entities because he is not looking at achieving incremental returns and will, it seems, be taking bigger market positions than others," he said.

At the other end of the risk scale stands the highly rated Blackrock Absolute Alpha Return and Cazenove UK Absolute Target funds.

One thing absolute return funds do have in common is higher than normal charges; this is because managers levy initial and annual charges as well as routinely take a cut of any outperformance. "There is no getting away from the fact that these funds are expensive to invest in. They are a relatively low-return product and a big chunk of money comes out if they actually do better than normal," Mr Kuo said. Initial charges can be as high as 5.5 per cent – although this can be heavily discounted when buying through an IFA or a fund supermarket – with annual charges of 1.5 to 1.75 per cent.

But Mr Davidson defends the charging structure of absolute returns. "These funds are more sophisticated than a standard unit trust and use more investment tools which cost extra. But admittedly the charging of performance fees can be confusing to investors. The key is to seek advice and ensure that the manager is making a good case for the fees they charge."

Likewise, Mr Norris thinks that many observers pay too much attention to the charges levied. "Frankly, the issue of performance fees is overplayed. Fees are often triggered only if the fund delivers, say, more than 5 per cent growth after fees. In addition fees are subject to a high watermarking – so lose 10 per cent one year but make 5 per cent the next year and the investor won't get charged a performance fee as the unit price of the fund has to reach a new high before they come into play."

As for what role absolute returns should play in an investor's portfolio, opinion is divided. "I think of absolute returns as a good core holding. Invest in areas such as emerging markets for a bit of high return but high risk potential. Have some absolute return funds to produce steady growth. It's all about balancing risk," Mr Yearsley said.

But Mr Kuo sees the concept of absolute returns as simply too expensive and surplus to requirements. "Look, there are four major assets that you should have: property, shares, cash savings and bonds. Think of your portfolio of these asset classes as in effect an absolute returns fund. Try to balance these four asset areas to produce steady long-term growth rather than pay through the nose for a fund."

And in 2010 with the world economy showing signs of returning to growth, Mr Kuo sees the stock market as the place to be. "Over the past decade, investors have reduced their share holding and favoured property and, to a lesser extent, cash. This year, with savings accounts paying so little and with property market problems, I'd say it's the year to build up your share holdings but cost of investment is important," said Mr Kuo. "For starters look at an exchange traded fund such as the Blackrock iShares which buys into the stock market as a whole at a tiny cost and without the need to pay a fund manager."