Protect against market storms

Darius McDermott, managing director of FundCalibre, has increased absolute-return fund exposure in client portfolios to help diversify them. And Colin Low, managing director of Kingsfleet Wealth, has reduced the fixed-income allocation of clients with balanced portfolios from around 30 per cent three years ago to 8 per cent, due to concerns about the bond market. The difference has been made up by an allocation of 8 per cent to absolute-return funds, 4 per cent to hedge funds and 14 per cent to other types of capital preservation fund.

Absolute-return funds can be a good substitute for bonds, particularly as the risk of losing money on bonds has increased as interest rates have started to rise around the world, according to Rory McPherson, head of investment strategy at Psigma. “[In such an environment] absolute-return funds could be useful for retirees drawing an income, and people who want stable and solid returns to protect their nest egg rather than massive growth," he says.

Absolute-return funds don't often make high returns but can provide a degree of capital protection, particularly at a time when stock markets are at record highs and many fixed-income assets look expensive.

However, targeted absolute-return funds are a mixed bag, with some investing in equities, others in bonds and a number investing across several asset classes. Absolute-return funds can also employ a range of investment strategies. These include long-short strategies that allow the funds' managers to buy equities, in the expectation that their prices will rise, and take short positions (bet on a company's share price falling). So long-short funds have the potential to profit from both rising and falling markets.

Global macro funds, meanwhile, take long and short positions in equities, fixed income, currency and futures markets to match their managers' big-picture thinking on the macroeconomic environment.

Some absolute-return funds employ market-neutral strategies, which means they aim for their short and long positions to have equal market value with a zero net market exposure. Net exposure is the percentage difference between a fund's long and short exposure, and a measure of how much a fund is exposed to market fluctuations.

Mr Low says: "Because absolute-return funds are so different from each other, if you can understand their differences you can get good diversification across the sector [by holding absolute-return funds that do different things to each other]."

The risks

However, because absolute-return funds take such different approaches, understanding exactly how one of them operates can be difficult. And because their managers often invest across several asset classes and strategies the funds' risk profile can change. So, if you invest in these types of funds you need a high enough risk appetite and long enough investment horizon to take on different levels of risk.

"We use absolute-return funds when there's a really strong case for using them, but they come with a big health warning as they can masquerade as very different things, with some funds having lots of equity characteristics and others having more in credit," says Mr McPherson."

Mr Low adds: "Just because funds are included in the Investment Association (IA) Targeted Absolute Return sector and have 'absolute return' in their name, doesn't mean they all behave in the same way. The main risk for investors is not fully understanding what a fund does."

For example, many people invested in Standard Life Global Absolute Return Strategies (GB00B7K3T226) but didn't really understand how it worked. This fund runs about 40 to 50 different strategies simultaneously and invests globally across equities, fixed income, currencies and advanced derivatives. It was very popular with investors and at one point had assets under management of £20bn. But a number of the team who originally managed it left and it made a negative return in 2016. The fund suffered outflows and now has assets of just under £18bn.

Although there are Targeted Absolute Return funds that have consistently made good returns, the sector's performance as a whole has been underwhelming argues Gary Potter, co-head of multi-manager at BMO Global Asset Management. His firm recently conducted some research which measured the percentage of time the average fund in the absolute return sector had beaten consumer price index (CPI) inflation plus 2 per cent or plus 3 per cent over a seven year monthly rolling period during the last 10 years. BMO found that on average, funds in the sector had only beaten CPI plus 2 per cent 17 per cent of the time, and had never beaten CPI plus 3 per cent over the period.

Investors also need to watch out for high costs as many absolute-return funds levy performance fees. "For products that are often just trying to generate a few percentage points of return, it is difficult to justify some of the performance fees they charge," says Patrick Connolly, certified financial planner at Chase de Vere. "Performance fees can be charged at 20 per cent of outperformance for beating a notional and irrelevant benchmark. That benchmark might, for example, be Libor rates which are less than 1 per cent a year. This isn't much of a hurdle."

And there is no guarantee these funds will make a positive return – despite their objectives. "Some absolute-return funds take too much risk, which means their investors could incur major and unexpected losses," says Mr Connolly. "In 2016, out of a total universe of 3,071 investment funds, three of the bottom four performers were in the Targeted Absolute Return sector. FP Argonaut Absolute Return (GB00B7FT1K78) lost 26 per cent, LF Odey Absolute Return (GB00B55NGS86) lost 18 per cent and Old Mutual UK Opportunities (GB00BBQ2T214) lost 12 per cent. It is astonishing that funds that supposedly aim to provide a positive return can lose so much."

You should also check how correlated absolute-return funds are to equity and bond markets. If they have a high correlation, when these markets fall the funds are likely to lose value too.

Because of the risks relating to absolute-return funds Mr Potter does not think investors should substitute their bond allocations with exposure to absolute-return funds.

"If these funds had shown more success consistently delivering inflation-beating returns, perhaps I'd agree with that idea, but there are better bond fund managers out there than there are absolute-return fund managers," he says. "And I don't believe that bond investing is past its sell-by date. The market for bonds is so vast that there are always going to be some niche bond investors that can do well by holding assets like floating rate notes, which would start to benefit if interest rates rise."

Targeted absolute-return funds that deliver on their aims

Despite these issues, there are several absolute return funds that have consistently achieved their objectives. Old Mutual Global Equity Absolute Return Fund (IE00BLP5S809) has made positive returns in each of the past five calendar years and a cumulative return of 29.9 over five years. And over three and five years to 18 June the fund had correlation coefficients of -0.24 and -0.13 to MSCI World index respectively, according to FE Analytics, demonstrating a very low correlation to global equities. Correlation coefficients are valued between -1 and 1, where -1 shows a perfect negative correlation, and 1 shows a perfect positive correlation. A correlation coefficient of 0, or very close to 0, shows no correlation.

The fund, which has been managed by Ian Heslop, Amadeo Alentorn and Mike Servent since launch in 2009, aims for positive returns in all market conditions over rolling 12-month periods by investing in global equities. It is a market-neutral fund, so is structured to move independently of global stock markets. As of 31 May, the fund had 814 positions, of which 384 were long and 430 short.

The fund has an ongoing charge of 0.81 per cent, but also a performance fee of 20 per cent of any returns it achieves above the average Bank of England base rate, provided its price has increased since the last time a performance fee was paid. The performance fee amounted to 1.65 per cent of the value of the share class in 2017 – on top of its 0.81 per cent ongoing charge.

Mr McPherson suggests Jupiter Absolute Return (GB00B6Q84T67), a global long-short equities fund that aims for absolute returns over three-year rolling periods, independent of market conditions. The fund takes a multi-asset approach and can invest in global equities, derivatives, cash, fixed-interest securities, currency exchange transactions and index-linked securities.

Mr McPherson says: "Its manager, James Clunie, is really skilled in shorting so he tends to do well when equity markets sell off."

The fund has correlations of only 0.01 per cent and 0.09 per cent with MSCI AC World Index over three and five years, respectively. But it is more closely linked to global bonds, with correlation coefficients of 0.71 and 0.64 over three and five years respectively, compared with Bloomberg Barclays Global Aggregate Index. Jupiter Absolute Return has also only delivered positive returns in three of the past five years. However the fund has a reasonable ongoing charge of 0.84 per cent and is one of the few absolute-return funds that doesn't have a performance fee.

Although not generally a fan of absolute-return funds, Mr Potter highlights Janus Henderson UK Absolute Return (GB00B5KKCX12), a long-short fund managed by Ben Wallace and Luke Newman since its launch in 2009. It aims for positive returns over 12-month rolling periods and the long term, regardless of market conditions. It typically invests at least 60 per cent of its assets via long and short positions in UK-listed companies, and companies that carry out a large proportion of their business in the UK. It has 181 positions. Its largest sector exposure is financials, and holdings in this area include Legal & General (LGEN), UniCredit (UCG:MIL) and Aviva (AV.). The fund's largest holding is housebuilder Bellway (BWY).

The fund has made positive returns in each of the past five calendar years and a cumulative return of 31 per cent over this period. The fund has an ongoing charge of 1.06 per cent, as well as a performance fee of 20 per cent on any returns it makes above the average Bank of England base rate.

Mr McDermott says: "We like this fund as, unlike many of its sector peers, it has achieved its stated aim, which is to provide equity-like performance but with one-third of the volatility."

However, the fund has moderately high correlations with the FTSE All-Share of 0.5 per cent and 0.6 per cent over three and five years.

BlackRock UK Absolute Alpha (GB00B5ZNQ990) is a long-short equities fund run by Nigel Ridge and Nicholas Osborne. It aims for absolute returns on a 12-month basis in all market conditions, but is not managed against a UK equity index. It has made positive returns in each of the past five years, over which period it has achieved a cumulative total return of 25.5 per cent.

Over five years the fund has a low correlation co-efficient of 0.21 per cent to the FTSE All-Share Index. But over three years its correlation co-efficient with the FTSE All-Share is 0.46.

Mr McDermott says: "Run by one of the best resourced and most experienced UK equity teams, BlackRock UK Absolute Alpha fund is a very useful portfolio diversifier, with much lower volatility than the UK equity sector average. Its managers take a pragmatic approach to stock selection, which we like, taking the macroeconomic environment into account as well as looking at each individual company's fundamentals."

The fund has an ongoing charge of 0.92 per cent and a performance fee of 20 per cent for outperformance of three-month Libor, subject to a high water mark.

City Financial Absolute Equity (GB00B2PX1C62) is a long-short fund that made a cumulative return of 56.3 per cent over five years. The fund has also made double-digit returns in four out of the past five years, although it made a loss of 10 per cent in 2016. It aims for positive absolute returns over rolling 36-month periods, primarily through investment in UK and global equities.The fund has a higher risk profile, so Mr McDermott says it could be of interest to investors with a higher risk appetite. "Anything that can give you 20 per cent return a year can also lose you 20 per cent a year," he explains.

City Financial Absolute Equity has been managed by David Crawford since 2008. The fund has correlation coefficients of -0.39 and -0.26 to the FTSE All-Share over three and five years, respectively, so has a moderately negative correlation with UK equities. It has an ongoing charge of 0.94 per cent and a 20 per cent performance fee, which is payable if it outperforms three-month Libor, with a permanent high water mark.

Suggested funds' annual performance

Source: FE Analytics as at 18/06/18, *Morningstar as at 18/06/18

Suggested funds' cumulative total returns

Source: FE Analytics as at 18/06/18