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Absolute rubbish?

Absolute return funds have been around for at least five years, but the financial crash of 2008 gave the sector a big boost. With many traditional, long-only funds taking a pasting in the performance tables, it was argued that absolute return's time had come. The investing world needed funds with more flexibility, in order to cope with such extreme volatility.

Around the same time, changes in fund regulation allowed many more funds to adopt flexible mandates. But the vast majority have singularly failed to live up to their promises, as highlighted in a recent piece of research by Investors Chronicle's sister publication, Money Management.

Failing to deliver?

The Investment Management Association (IMA), the trade body for the UK funds industry, defines absolute return as funds which aims to deliver "absolute (more than zero) returns in any market conditions. Typically, funds in this sector would normally expect to deliver absolute (more than zero) returns on a 12 months basis."

The definition is the first problem. "I would suggest that these funds should produce a return in excess of a one-year fixed deposit at a leading bank or building society," says Rob Pemberton, investment director at wealth managers HFM Columbus Asset Management. "Assuming this was 2.75 per cent then there is a raft of funds not producing even a minimum level of return, including funds from GLG, SWIP and Ignis."

Only around 16 absolute return funds currently have returned more than 2.75 per cent over one year. Most of the 36 absolute return funds for which data is available over 12 months (to 2 December) have made positive returns, but these vary from just over 0 per cent to just under 12 per cent. Funds offered by Gartmore, Threadneedle, Baring and Cazenove are among those that have lost money over 12 months (to 2 December.) If you take into consideration the funds' fees, which often include performance fees, then even fewer of these are delivering a meaningful return.

Another problem is comparisons. They may sit in the same sector, but many funds use very different strategies, benchmarks, risk/reward characteristics and compositions. This means they will perform differently at different times, so it is difficult to compare them and establish which are best.

For example, of the funds with a three-year track record, most have produced impressive double digit returns of more than 20 per cent, but most of these are bond funds driven by the strong bond market of the last few years, so you cannot tell if this is manager skill - or market-tracking performance that will tail off when bonds stop doing well.

The varied nature of absolute return funds also means that some are much more volatile than others, at times offering excellent returns, but then incurring far greater losses, rather than preserving wealth and smoothing returns. For example, CF Octopus Absolute UK Equity returned more than 42 per cent in 2009 but year to date 2010 is down 14.2 per cent.

Plus side

A number of funds have been doing what they should, even if the sector average does not look good. "With the exception of the volatile CF Octopus Absolute UK Equity Fund, the funds that have produced a negative return have kept this loss of capital to only a few percentage points," says Mr Pemberton. "Thus, in terms of capital preservation the sector has done well, the caveat being that this has been by and large in a period of rising markets."

When absolute return funds do what they should, they can be useful as cash proxies when interest rates are very low as at present, and for investors who wish to preserve wealth rather than make huge returns. You should remember, however, that these funds are far riskier than cash, as evidenced by the fact that a number are losing money or failing to deliver even the low total returns that cash does.

Absolute return funds with good one year performance

Fund1 yr return %2008 return %TER (%)
L&G Diversified Absolute Return 12.41NA1.67
City Financial UK Equity Inc Forrester 10.92-33.391.86
City Financial UK Equity Inc10.41-33.631.84
CF Whitefoord Absolute Return9.992.232.42
CF Odey UK Absolute Return9.65NA1.47
Standard Life Global Absolute Return Strategies9.46NA1.60
SWIP Absolute Return UK Equ9.52-29.661.65
Absolute Insight Fund of Funds8.99NA1.82
Scottish Widows HIFML Absolute Return 28.79NANA
Henderson Diversified Absolute Return8.36-37.86%1.66

Source: Morningstar data, as at 6 December 2010

For more on absolute return funds that have performed well, see

Alternatives

If you're unconvinced about the sector's performance, and resentful of the performance fees when absolute-return funds do perform, then there are alternatives.

■ You could hold a combination of cash and a FTSE 100 tracker. Independent financial adviser Chase de Vere has conducted research which shows finds that the average performance of absolute return funds against a portfolio which comprises 25 per cent FTSE 100 and 75 per cent cash produce similar returns. Therefore, as cash and a tracker incur relatively no costs in contrast to the higher charges and possible performance fees of absolute return funds, they could be a better option.

■ The best cautious managed funds are better at preserving capital. CF Ruffer Total Return Fund has made excellent long-term returns topping the cautious managed sector over three years with nearly 50 per cent and five years with 55 per cent, and made positive returns in most calendar years over the last ten. This is also the case with the Troy Asset Management Trojan Fund, which has a strong capital preservation bias. However, cautious managed funds vary widely in terms of risk and volatility, and may go down in bad years - such as 2008, when the average cautious managed fund fell 16 per cent.

■ Multi-asset funds have more flexible mandates, like absolute return funds. Artemis Strategic Assets is a multi-asset fund but has a number of the characteristics of a hedge fund, for example the ability to short-sell stocks and use derivatives. It is run by William Littlewood, who has been very successful with past funds. However, it is only just over a year old so there is not much of a performance record. Nevertheless, we tipped it in August 2009 and over one year the fund has returned 17 per cent, placing it comfortably among the top quartile of actively managed funds. .

Another approach is for investors is to construct their own carefully blended multi-asset portfolio with the aim of capital preservation, rather than relying on an absolute return fund as a one stop shop.

Hardy investment trusts

If you are making lower returns as a result of holding a more cautious fund, then it is a good idea to keep fees lower, so you could consider investment trusts which generally have lower fees than open-ended funds.

Some of these vehicles are run with a strong wealth preservation emphasis, such as RIT Capital Partners and Caledonia, although the latter trust has recently had some performance problems. Ruffer Investment Trust is run by some of the same team as CF Ruffer Total Return and has held up in years such as 2008.

Personal Assets Trust has made strong long-term returns and been taken on by Troy Asset management, who also run the Trojan Fund. It only lost 3.18 per cent in 2008.

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