Target the absolutely right fund

Rob Pemberton, investment director at HFM Columbus Asset Management, hasn't been a huge fan of absolute return funds in the past (read more on this). But he now argues that as bonds and other fixed income products struggle in volatile investment conditions, there is a strong case for investing in certain long/short absolute return funds, run by managers with a history of delivering significantly above average returns and who preserve capital.

Pete Doherty, manager of the Tideway UCITS - Global Navigator Fund, says that yields to maturity after fees on gilts and corporate bonds, traditionally used to limit downside, are typically below 3 per cent after fees, and so less than inflation, currently 2.7 per cent. And if interest rates rise, you could experience capital loss on these assets. So he argues that there is a need to have some allocation to absolute return funds to limit downside.

Targeted Absolute Return funds use similar techniques to hedge funds to try to achieve positive returns in all conditions. But they conform to European Union rules that govern funds, so are not able to do all the things that traditional hedge funds can, but are less risky and complicated. They are also available to private investors, which is not the case with traditional hedge funds.

However, over the past few years absolute return funds have attracted a lot of criticism because, despite their aim of providing regular positive returns through all markets, many have failed to do this (read more on this).

"Long/short equity funds have something of a tarnished image in the eyes of UK retail investors," says Mr Pemberton. "But the current fund offerings in the UK retail space are far less sinister. They still use some derivatives but now are straight forward, Financial Conduct Authority regulated, onshore, daily-dealt funds offered by established UK-based investment houses."

The purpose of a long/short equity fund is to provide positive returns by being long of stocks with superior return characteristics and short of stocks with inferior return profiles.

"Typically, these funds will also have some net market exposure, which is a key figure investors need to be aware of," adds Mr Pemberton. "So, if a fund has a net exposure of 40 per cent - 40 per cent more long exposure than short exposure - it means the fund is 40 per cent exposed to the movement of the underlying market itself. Thus, if the market rises by 10 per cent, and assuming no value is added through stock selection, the fund will then rise by 4 per cent. Conversely, if the market falls by 10 per cent, then the fund would expect to fall by 4 per cent."

Problems persist

But others argue that by and large absolute return funds continue to fail to deliver.

Last year, chartered financial planner Informed Choice conducted research that found only three out of 51 absolute return funds are suitable for private investors (read the report). These were Henderson Credit Alpha (GB00B3KTJD38), Insight Absolute Insight (GB00B1SVX910) and IC Top 100 Fund Newton Real Return (GB0001642635). Informed Choice applies a screening process to find funds that demonstrate consistent risk-managed returns with low total expense ratios (TERs), and to qualify they need to score above 80 per cent.

Informed Choice ran the same analysis as at 7 November 2013, and found that again only three absolute return funds score above their minimum 80 per cent suitability threshold. This time the three funds are Henderson Credit Alpha, City Financial UK Equity (GB00B2PX1719) and Cazenove UK Absolute Target (GB00B39VWX15).

Martin Bamford, managing director of Informed Choice, says: "These funds are typically inconsistent, have high charges and are difficult for investors to understand. They also tend to distort the overall asset allocation of a portfolio and make overall risk levels very difficult to control."

Meanwhile, research by wealth manager Brewin Dolphin finds that the average absolute return fund is highly correlated with the FTSE All-Share.

"It appears the typical Target Absolute Return fund manager is merely assuming a modest amount of equity risk while leaving the vast majority of assets in cash," says Ben Gutteridge, head of funds research at Brewin Dolphin. "The net result for the client is simply a lower risk and lower return iteration of equity market performance. The sector, on average, therefore, is a poor diversifier of risk assets, and should be treated with trepidation in regard to the role in which it actually fulfils within portfolios. This is particularly the case given funds of this nature typical levy a rather odious performance fee."

Some absolute return funds charge higher fees than the average equity-based long-only open-ended fund, in particular because a number levy performance fees. Often this is set at a benchmark over cash, which Mr Gutteridge says is unfair if the fund has a large long equity position, making it easy to beat cash.

In addition, Libor, the primary benchmark for short-term interest rates has historically been higher than inflation, meaning that funds seeking to beat this would need to deliver positive returns after inflation before a performance fee could be levied. But interest rates have been significantly below the rate of inflation over the past few years, meaning funds can still charge a performance fee even if they have failed to keep pace with inflation, provided they beat Libor.

Mr Doherty argues that if a fund makes less than 5 per cent after fees including adviser or platform charges, it is giving you a similar return to a three to five year cash deposit - or less - but at a much higher risk.

Absolute return funds' overall returns may not be as strong in environments of zero interest rates as they were pre-crisis when interest rates were at 5 per cent because heavy users of derivatives often have high cash weights.

Another difficulty with the Targeted Absolute Return sector is that these funds differ from each other in the way they are managed, making it harder for investors to understand the underlying investment strategy and compare them to each other. Their risk profile and volatility varies widely, and they also invest in different assets to each other. The IMA admits that because of this performance comparisons across the whole sector are inappropriate.

Choosing an absolute return fund

With most funds you probably examine the long-term cumulative total returns, but with absolute return funds, you are probably better off looking at the annual returns. These should be ideally all, or mostly positive.

Barry Norris, manager of the IM Argonaut European Absolute Return Fund (GB00B7FT1K78), says: "A discerning investor would do well to see whether a fund manager achieved a positive return in 2011, when equity market returns were double-digit negative - and should be looking at both the net and gross exposure of long short equity funds, whether they have added value in their short book as well as long book - and the standard deviation and beta of the fund versus the market."

When analysing fund returns you need to consider what has been produced by stock-picking and what has been produced by the free ride of being net long the market, according to Mr Pemberton. "From the capital preservation standpoint, the key components to analyse are the volatility of the fund and the maximum drawdown - the fall in the fund from its highest to lowest point which shows the maximum percentage amount of capital an investor could have lost," he says.

James de Bunsen, multi-asset fund manager at Henderson, says: "The market backdrop and dynamics are crucial: systematic strategies don't work in markets without strong trends; fundamental long/short equity strategies won't work in highly correlated markets; merger arbitrage funds can't make money if there is no deal flow."

Also, check the fund's fees, and the terms and conditions of its performance fee, if it has one.

BEST ABSOLUTE RETURN FUNDS

We include Newton Real Return (GB0001642635) in our IC Top 100 Funds. This has delivered a positive return even during the financial crisis in 2008. It invests predominantly in UK and international securities, but can also use deposits, money market instruments, derivative instruments and forward transactions.

Mr Pemberton recommends Cazenove UK Absolute Target, Threadneedle UK Absolute Alpha (GB00B518L045) and Jupiter Absolute Return (GB00B5129B32). "The Threadneedle and Cazenove UK equity managers both come from excellent long-only stables and have an established track record of running long/short money," he says. "The Jupiter fund is the former Philip Gibbs macro fund, newly re-launched under the management of James Clunie, a renowned long/short manager formerly with SWIP. The Jupiter and Threadneedle funds will typically have a net exposure of around 30 per cent, the Cazenove Fund a touch lower."

Jupiter Absolute Return Fund had been performing poorly (read more on this), but Mr Clunie has run it since the start of September this year (read our report). He previously ran the SWIP UK Flexible Strategy (GB00B1265J60), an IC tip which has made a positive return in each of the past four calendar years during which time Mr Clunie ran it, as well as roundly beating its benchmark, three-month Libor.

"An interesting exercise is to look at the three-year returns and volatility of these funds in relation to those of the average fixed income fund over the last three years," continues Mr Pemberton (see table). "The Jupiter fund is excluded as its past record is of no relevance given it was not previously a long/short equity fund. The data reflects the fact that the two long/short UK equity funds have produced near equity market returns with far less volatility and threat to capital. Their returns pattern is similar, in fact superior, to that of a typical fixed income fund, displaying the attributes of low volatility and capital preservation we are looking to achieve with these investments."

Source: HFM Columbus/Financial Express Analytics

Data to 8 October 2013

Another fund which has delivered on its aim with positive returns every full calendar year since launch in 2008 is Standard Life Global Absolute Return Strategies (GB00B28S0093), which we tipped earlier this year.

Mr Gutteridge suggests Henderson UK Absolute Return (GB00B5KKCS68), which aims for a positive return over the long term and typically every year, by investing in UK company shares and using derivatives. It has achieved positive returns year to date, in 2012 and 2010.