The Analyst: A foot in both camps can pay off

In my last column of 2007 I said that the outlook for 2008 was particularly cloudy. The majority of press comment has been generally gloomy and talks of housing recession on the back of the problems in the US. That said, we do know that UK and US interest rates are going to be reduced quite sharply this year probably by at least 1 per cent.

Equity markets have a considerable amount of bad news already priced in, so I think it would be wrong to be completely avoid the markets. As ever, we investors want everything – we want to participate in the market gains, but don't want to be around when it loses. In fact, what we actually want is a hedge fund.

Unfortunately the vast majority of hedge funds are not open to retail investors, nor are they open to intermediaries to market them as they are unregulated investments. A proper hedge fund will try to make absolute returns and preserve capital in downturns. The hedge funds that you often see hitting the press, usually because something horrible has gone wrong, are in fact not what I would really call hedge funds but more like out-and-out gambling funds. So it has been difficult for the retail financial industry in the UK to launch anything like a hedge fund.

However, there is one group that seems to have launched a genuinely alternative product: the BlackRock UK Absolute Alpha Fund. I admit to being a little sceptical when it launched on the back of the expanded UCITS III regulatory regime. I was concerned that the powers might not be enough to deliver the kind of absolute return fund that was being proposed. I'm happy to have been proved wrong so far, and Mark Lyttleton has done a cracking job managing the fund.

The fund attracted little attention during a raging bull market: an environment in which it is bound to underperform. It has really shown its worth during the volatility of 2007. The All Share went through a roller-coaster ride and finished up 5.3 per cent, but the Absolute Alpha Fund delivered a gain of 10.8 per cent with significantly less volatility.

This is the nearest thing I can find to a regulated hedge fund. It adopts four investment strategies. Firstly, traditional long positions where Lyttleton has strong conviction that a stock will rise. Secondly, synthetic short investing, where he has a strong conviction that the stock will fall. When searching for short ideas he checks for companies with poor fundamentals or where he can see a catalyst for a negative reappraisal of the stock.

The largest part of the portfolio is invested in the third strategy: pair trades. These are a combination of long and synthetic short investing. These are often employed for two stocks in the same industry, where Lyttleton believes that one company is likely to outperform another. Providing he gets this call right – that Stock A outperforms Stock B – then he will make money regardless of whether the stocks fall or rise. The fourth tool available to Lyttleton is cash; he has the freedom to invest up to 100 per cent of the portfolio in cash.

The portfolio is run with a total return mandate; the aim is to consistently produce positive returns. Because the long and short positions in the pair trades are equal, the combined bet has a net market exposure of zero; it is this that gives the fund its very low volatility compared to the market. Throughout the life of the fund its total net market exposure has typically been no more than around 15 per cent.

So where could this fit into a portfolio? I am tempted to suggest that funds like this could be core holdings. It will clearly under perform during a bull market, but its considered approach should lead it to deliver good long term returns in the hands of a capable manager. Compounded returns of 8 per cent will double your money in nine years.

The fund could also be used tactically if you feel you are clever at market timing. For example, after a bull run, a fund like this could be very useful in delivering capital preservation to Sipp and ISA portfolios during a downturn. It also has daily dealing now, which will make it much easier for investors to handle.

In conclusion, I believe the BlackRock fund gives investors a chance to have a foot in both camps. If you think the market might go up, this will, or should, participate in some of the market gains, although not fully in the big bull run. On the other hand, should the market take a downturn, it should preserve your capital and with luck, make a little bit. The fund could also be used as an alternative to bond investing, but it could also be used to dovetail with more volatile long-only funds, or more sector specific funds which should help to reduce the volatility of your whole portfolio.

The writer is the head of research at Hargreaves Lansdown, the asset manager, financial adviser and stockbroker. For more information about the funds included in this column, visit www.h-l.co.uk/independent

cash@independent.co.uk