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Seeking a smooth ride

Despite the apparent end of the financial crisis, markets continue to be spooked by new problems such as Greek sovereign debt problems, the effects of austerity measures in the UK and uncertainty as to whether we are entering a double-dip recession, high inflation or even both. In short, it looks like a rough ride for investors. But there are funds you can turn to, to smooth things over and maintain returns.

One way to lower the volatility of your portfolio is to diversify it with different types of funds and balance riskier assets with lower-risk ones. But even if you are invested in a range of different areas, they can still be correlated, so ensure your assets are subject to different drivers.

Tim Cockerill, head of collectives research at Ashcourt Rowan Asset Management, says: "Under most market conditions there is a variance between assets and, over the longer-term, this should make your portfolio more consistent."

He says you should mix the three portfolio staples: equity, bond and property funds, and vary it further by adding absolute return funds.

Absolute solution?

Hedge funds or absolute return strategies tend to aim for a set return above zero every year rather than beat the market, and therefore should help to provide stable returns through all markets. These types of funds had only been available to large institutions such as hedge funds, but over the past few years a number of absolute return funds have launched for small investors that conform to Ucits III (Undertakings for Collective Investment in Transferable Securities), European Union rules that govern funds. The Ucits III versions use similar techniques to hedge funds, but operate within a regulated structure.

A problem is that most Ucits III compliant absolute return funds don't have a track record of more than three years. But, argues Robert Burdett, head of multi-manager at Thames River Capital, absolute return funds proved themselves during the financial crisis, with the sector making an average return of 3.6 per cent between March 2008 and March 2009, in contrast to Cautious Managed funds which fell 16.5 per cent and global equities which fell 23.5 per cent. Even the worst performing of the absolute return funds only fell 8 per cent.

"These are a worthwhile addition," says Mr Burdett. "Although the funds are relatively new, the quality of their managers is high because they use sophisticated techniques such as shorting. A number of the star fund managers who were running hedge funds are now running Ucits III absolute return funds."

When choosing a fund, even if it does not have a long track record, you can look at the record of their managers, which is not a bad proxy, says Mr Cockerill. For example, the Jupiter Absolute Return Fund only launched in December 2009 but its manager Philip Gibbs has managed funds including offshore absolute return strategies for more than 10 years.

Mr Burdett adds that over the past three years absolute return funds have shown themselves to generally have low volatility.

Caveats

Absolute return funds aren't without their caveats. While these funds aim for steady returns above zero, they do not guarantee them, and do not necessarily always have low volatility. "An absolute return fund aims for a steady upward direction by going long and short, but this still depends on the fund manager making the right decision, and they can get the long and short both wrong," says Mr Cockerill.

Another difficulty with the sector is that absolute return funds differ from each other in the way they are managed. There are several techniques or combinations of techniques managers can use, thereby making it harder for investors to understand the underlying investment strategy. The risk profile and volatility of the funds in the Investment Management Association (IMA) absolute return sector also varies widely.

Rob Pemberton, investment director at wealth manager HFM Columbus, believes the absolute return sector is giving investors a misleading impression. "What is happening in practice is that many funds have a high market exposure, sometimes 50 per cent or more, and thus get a free ride if the market rises - but risk considerable losses should the market fall," he says. "Clearly, in current conditions where we have a falling market, most sectors are going to be hit - the problem here is that the fund managers appear to give the impression that they will weather any storm over a 12-month period, and I don't see how that is possible."

Although absolute return funds held out between 2008 and 2009, there were only 16 funds in the sector at the time - now there are more than 40.

Mr Pemberton is also concerned that a number of the funds do not hedge most of their equity market exposure making them 'neutral'. He adds that some of the funds which have done this, such as BlackRock UK Absolute Alpha, have made a flat return over the past 12 months, although prior to this the fund had returned around 8 per cent a year. Mr Pemberton adds that Cazenove UK Absolute Target and SVM UK Absolute Alpha have lost around 3 per cent year to date, while CF Octopus Absolute Equity UK has lost around 15 per cent, in contrast with a fall of 2 per cent for the FTSE.

Bucking this trend is the Standard Life Global Absolute Return Strategy Fund, which Mr Pemberton says has returned 18 per cent. But he expresses concern over the "complicated" and "opaque" nature of the fund, adding that the fund's fact sheet does not disclose its market exposure. Mr Pemberton says that you should know exactly what you are buying if you wish to maintain control of your portfolio's volatility and risk.

Standard Life, in turn, argues that market exposure figures are not important in the context of the way the fund is run."Different absolute return fund managers will provide investors with different breakdowns/analysis, usually because it is more appropriate given the investment approach of the fund. For example, net equity market exposure would be particularly pertinent in relation to a long/short equity fund, but this figure in relation to a multi-asset or multi-strategy fund will only give part of the picture," comments Hilda Stewart, press manager at Standard Life investments.

Diversity

A better way to diversify exposure, according to Mr Pemberton, is multi-asset managed funds.

These can be of particular benefit to investors with smaller portfolios that do not have the critical mass to invest across several different types of funds, due to the minimum entry of £500 or £1,000. Asset allocation decisions are outsourced to a manager, which is beneficial if you don't have the time to manage this, or lack the expertise. With a likely rise in capital gains tax (CGT), these funds should also be more tax-efficient. The sale of a fund by an individual investor incurs CGT but when a fund manager switches a fund within a wrapper, such as a multi-asset fund, it does not.

Mr Pemberton in particular favours funds run by private client or family offices, which run their publicly available funds along the same lines as their private money. "Ruffer Total Return Fund and Troy Asset Management's Trojan Fund are rather old school in nature, having a private client or family office mentality of aiming to protect investors' capital and steadily increase its value year on year. They have delivered precisely this objective over the last 10 years," he says. "For a lot of people exhausted by the markets, they are a good solution, as their number one priority is to avoid loss."

Mr Pemberton also likes the Artemis Strategic Assets Fund, which has made impressive returns over the past year, although it only has a one-year track record and is not run by a family office. The fund is slightly higher risk as it is predominantly invested in equities (75 per cent of the portfolio at the end of April).

"The proof of the pudding is that the Ruffer, Trojan and Artemis Funds have all produced year-to-date positive returns in 2010 of around 6 per cent after double-digit gains in 2009," says Mr Pemberton. "They have significantly higher market exposure and hence potentially higher risk/reward profiles than many absolute return funds, but this risk is transparent to investments and the funds have over time demonstrated that they can control this risk to produce steady returns and preserve investors' capital."

Mr Cockerill also acknowledges the importance of wealth preservation but says that while this may be suitable for those with substantial fortunes, smaller investors tend to need to grow their assets with higher-risk, higher-return investments. They should therefore focus on a mixture of wealth preservation and growth.

Like absolute return funds, multi-asset funds may not fully participate when the market goes up and typically have higher total expense ratios (TERs), as a number of them are funds of funds which can have TERs of over 2 per cent, which will eat into your returns.

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