Time to reconsider absolute return funds?

"The more and more equities rally the more and more you should be thinking about buying hedge funds because equities might be due a correction," says Andrew Summers, head of fund research at Investec Wealth and Investment.

Funds that enable investors to access hedge fund strategies have seen rising inflows from investors since 2008, in a search for greater diversification and flexibility. According to a survey released earlier this month by Deutsche Bank, the number of institutional and retail investors in liquid hedge fund alternatives grew to 51 per cent from 28 per cent year on year.

These absolute return funds offer a more transparent way of accessing hedge fund strategies than direct investment in unregulated hedge funds, which are made available only to certain sophisticated or accredited investors, and cannot be offered or sold to the general public.

Laith Khalaf, senior analyst at Hargreaves Lansdown, warns: "When you do invest directly in hedge funds there is a complexity issue because often these funds are registered offshore, so reporting may be relatively opaque and pricing may not be transparent."

By contrast, the Investment Management Association (IMA) Targeted Absolute Return sector comprises 76 funds that are traded daily and therefore have daily pricing. Their strategies seek to provide steady, cash-plus returns with lower volatility than equities, regardless of market movements.

Investors can also access hedge fund strategies via the 24 investment trusts in the Association of Investment Companies' Hedge Fund sector, plus there are several global growth investment trusts that follow absolute return strategies.

Diversification potential

Hedge fund performance has been relatively weak over the past three years. According to data from Prequin, UCITS hedge funds returned on average 1.72 per cent during the second quarter of this year and 3.37 per cent annualised over the past three years.

However, Mr Summers says investing in hedge fund strategies is not just about chasing returns and buying the funds that performed the best over the past one, three and five years. "I wouldn't say the ones that have struggled are bad," he says. "It may be the case that funds that have struggled in the last few years when equity markets have done well might actually have been doing exactly what they're supposed to be doing."

He stresses the role these types of funds should play in diversifying your portfolio and providing downside protection.

Rob Harley, senior research analyst at Bestinvest, also says he uses hedge fund strategies for diversification purposes. "What you will generally find is people who have a more defensive risk profile might want to consider allocating a high percentage of their portfolios to these types of products," he says. "Because these types of products are designed to try and achieve a positive return across all market eventualities."

These strategies can aim to achieve a return that is uncorrelated to equities by taking a market neutral approach, hedging out most market risk but doing arbitrage strategies that look to capture idiosyncratic risk.

Alternatively, some funds, typically trend followers, will go both long and short to try and make money when markets fall.

Cecile Astier, senior hedge fund consultant at Morningstar, says: "If you were to have an especially low cash environment where interest rates are really low, and you want something that has relatively little to do with [it], as well as a low volatility and cash link, it's probably best to go with a market neutral product."

Mr Harley says investors with a low risk profile can easily invest 20 to 25 per cent of their portfolio in absolute return strategies.

"The more defensive the profile, generally speaking, the higher the allocation to these absolute return vehicles," he says.

Best absolute return funds

Mr Khalaf recommends Newton Real Return (GB0001642635), also an IC Top 100 Fund, as a "fairly vanilla" fund that targets cash plus 4 per cent over five years before fees.

The fund follows a broad, multi-asset approach, investing in assets including equities and bonds as well as gaining exposure to commodities, currencies and property through listed investments and derivatives. It has consistently outperformed its benchmark, even over five-year periods that include the 2008 financial crisis.

Mr Khalaf also rates the Troy Trojan Fund (GB00B01BP952) a buy. This low-risk fund invests substantially in UK and overseas equities and fixed income securities but may also invest in money market instruments and collective investment schemes.

"It's a simplistic fund which has an eye for capital preservation and can use various tools," says Mr Khalaf. "That's the key, a flexible range of tools to achieve their goal."

Mr Harley and Mr Summers like Standard Life Global Absolute Return Strategies (GARS) (GB00B28S0093), which has returned 7 per cent over the past year to 24 September.

The fund has a return target of 5 per cent every year over cash in every rolling three-year period before fees. It is invested across traditional asset classes, such as equities and bonds, as well as more sophisticated, derivative-based instruments.

"The investment team uses a number of discrete uncorrelated strategies, each reflecting a specific investment idea, which are each intended to provide small, incremental returns," says Mr Harley.

For example, in August, the fund's managers established a relative value strategy for a portion of the portfolio to express their expectation that European banks would outperform the broader European equity market. They say that the banks are particularly well leveraged to economic recovery in the region, and as provisions for bad loans fall and loan growth picks up, their return on equity should increase. Moreover, should the European Central Bank embark on a programme of quantitative easing, the fund's mangers believe Europe's banks would be major beneficiaries.

Three members of Standard Life GARS' senior investment team last year left to set up a similar product at Invesco, the Invesco Perpetual Global Targeted Returns Fund (GB00B8CHCY21). However, Mr Harley thinks that "the strength and the depth of the team is still there".

Standard Life GARS has no performance fee attached and has an annual management charge of 0.75 per cent.

BH Macro Investment Trust (BHMG), another IC Top 100 Fund, is another good option for investors looking for downside protection.

The investment trust invests all of its assets in the Brevan Howard Master Fund, which aims to deliver consistent growth over the long term. The portfolio's exposure is predominantly to global fixed income and foreign exchange markets, via a combination of global macro and relative value trading strategies.

Nick Maunder, investment analyst at Canaccord Genuity Wealth Management, says you should be aware that an investment trust's share price can vary from its underlying net asset value (NAV) depending on supply or demand for the shares.

This can increase volatility in your return stream as well as the level of equity correlation in your portfolio - the opposite of the investment's intended effect.

However, Mr Summers argues this variance in price can be an opportunity for investors. "You can buy a trust at a discount or sell at a premium, which is an added potential source of return," he says, and adds that another plus is that investment trusts do not have to accept inflows or outflows from investors, making it easier for the fund manager to manage the investment strategy.

Over the past year to 24 September 2014, BH Macro's share price performance is down 5 per cent, and the trust is trading at a discount to NAV of 4.9 per cent.

However, the manager regularly buys back shares in order to control the discount, says Mr Summers. "We would expect it to produce capital when equities fall and I would also expect it to do well when interest rates start to rise," he says.

Mr Harley recommends Threadneedle UK Absolute Alpha Fund (GB00B518L045), which employs a long/short equity strategy and targets an annual return of 10 per cent.

Its mandate is not strictly market neutral, therefore some market directionality may be evident in the fund. "The fund was launched in September 2010, so the process has been tested across some volatile market conditions," says Mr Harley.

However, the fund has a 20 per cent performance fee as well as a 0.75 per cent annual management charge. Despite this Mr Harley likes the fund's good track record, established process and the fact its assets under management are not too high. "Some managers can gather too much money and this can compromise their investment strategy and performance going forward," he says.

Recommended hedge funds and absolute return funds

Source: Morningstar, as at 22 September 2014. Table shows cumulative total returns.

Performance versus fees

As with direct hedge fund investment, fee structures put in place for their liquid counterparts are higher than many other investment classes.

Some investors have questioned whether the so called 'two-and-20' typical fee structure - where managers charge a fixed fee of 2 per cent of the assets invested with them and 20 per cent of any profits they make - can be justified in light of recent performance.

However, Mr Khalaf says he has seen an improvement in performance fee structures among managers.

"There still are funds that have performance fees," says Mr Khalaf. "We have pointed out to quite a few of these funds that actually beating cash at the moment is not a particularly outstanding thing to be doing and probably you shouldn't be taking 20 per cent above cash as a performance fee."

Mr Harley says he has also seen more pressure on managers to drive down their performance fees.

"I would argue if you're paying a performance fee on these funds you should be asking the manager at what point they will consider closing the fund just so it doesn't start compromising the performance of that fund," he says.