Mark Dampier: Absolute return funds have long-term potential

The Analyst

Rather than concentrating on one fund this week I thought I would take a more general look at the absolute return sector, an area which has been something of a mixed bag in 2010. The aim of funds in this sector is to preserve capital (that is to say they try not to lose much money) and to provide steady incremental gains, generally averaging 5 to 10 per cent a year, regardless of the direction of the stock market.

We have clearly seen a rampant market over the last couple of years so the modest returns made by absolute return funds has appeared pedestrian by comparison. To compound the problem some fund's strategies have simply not performed, so I am not surprised some investors feel disappointed.

Despite this I still feel absolute funds have an important place in investors' portfolios. We have seen two occasions in the last decade where the FTSE 100 has fallen by nearly half, and it is during these turbulent periods when absolute return funds can really come into their own, particularly for those running retirement portfolios in a SIPP or drawdown. The importance of preserving and growing capital in such an environment can help offset the inevitable falls in other assets, helping you emerge from the downturn in reasonable shape.

Although absolute return funds are lumped together in one sector, in reality they represent a variety of different styles and strategies. One fund can't have all the answers in all environments, so it makes sense to build a portfolio of absolute return funds that complement each other. In general there are two main types: those that sell short and those that don't, and a combination of these should give you reasonable diversification. In the latter camp, Newton Real Return and Troy Trojan (actually in the Balanced Managed sector, which shows you really need to look under the bonnet of these funds) are well worth considering. In the former, I remain a fan of Tim Russell's Cazenove UK Absolute Target and Jupiter UK Absolute Return run by Philip Gibbs – despite recent lacklustre returns.

Philip Gibbs probably experienced the worst performance of his career in 2010. The main issue was that he was far too defensive, plus his foreign currency strategies didn't pay off as sterling was relatively strong. However, to write him off based on a single year is ridiculous given his fine record since 1997. I am reminded of the much celebrated Anthony Bolton who had many a year in the wilderness, particularly in the 1990s, before going on to excel. I recall defending Mr Bolton on a number of occasions, much like I have been doing with Mr Gibbs of late. I agree with Mr Gibbs that the global economic outlook remains highly uncertain and will probably do so for a number of years. Sovereign debt, inflation and a Chinese economic slowdown are all potential hazards. Having his fund in your portfolio, which can adapt to changing circumstances, could be a real help.

The recent "risk-on risk-off" market volatility has caused problems for many funds that use shorting, and it has been a particularly difficult time for Tim Russell whose portfolio is broadly speaking long defensives and short commodities. For the last 18 months there has been a distinct lack of diversification within equities. When risk is "on" commodities drive the market higher and defensives lag. When risk is "off" all equities including defensives fall, so the fund has struggled. Yet I can't help feel with so many portfolios having a high correlation with emerging markets and commodities holding this fund could well pay off at some point. The trouble is I don't know when, but I retain it in my own portfolio as an insurance policy against a commodities sell-off.

Despite the subject of today's column, I remain quite upbeat regarding stock market returns in 2011, and in a continuing bull market absolute return funds will clearly underperform. However, it would be a mistake to ignore the sector; these funds should help your portfolio through during difficult times. True, you need a degree of patience to hold them, but one day you will be glad you did.

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