Some 44 per cent of funds within the IA Targeted Absolute Return sector charge a performance fee, according to data from FE Analytics, but professional fund pickers argue that this is hard to justify at a time when markets have been a persistent upward trend.
The sector, which has a 105 constituents, is often popular with investors looking to increase the downside protection of their portfolios, particularly during falling markets. Indeed, the peer group has been among the Investment Association’s best sellers over the past few turbulent months.
A majority of funds in the sector aim to achieve positive total returns over rolling time frames irrespective of market conditions and do so through the use of both long and short positions and advanced derivate techniques, as well as holding traditional assets.
Given the complexity of the funds, their charges figures are often slightly higher than most of their peers.
Data from FE Analytics shows that the average fund in the IA Targeted Absolute Return sector has a clean ongoing charges figure (OCF) of 1.11 per cent while the average fund across all IA equity sectors (including global and emerging market funds, which are often expensive to run given the large research teams required) charges 1.07 per cent.
10 IA Targeted Absolute Return funds with highest OCFs
Source: FE Analytics
However, some investment professionals have begun to shy away from the sector – particularly from those that charge performance fees – given that many of them often produce single-digit returns over the medium term while, in some cases, adopting an OCF in excess of 2 per cent. 
Combining this with the fact that almost half of these funds charge a performance fee which is applied during rising as well as falling markets, some believe that a number of funds in the sector aren’t as much of a safe bet as they’re perceived to be.
FE Alpha Manager David Coombs, head of multi-asset at Rathbones, said: “When funds take performance fees for any positive return or above cash when cash is sub 1 per cent, I think it’s outrageous. I can’t put it any stronger than that, it’s dreadful.”
“I also think that when interest rates were 4 or 5 per cent, that was almost like a free hit for absolute return funds.”
“Just to generate 1 or 2 per cent of performance above cash, I’m not saying it’s easy, but that should be what the fund does. You shouldn’t get a performance fee for beating cash by 1 or 2 per cent.”
Coombs, who runs a number of funds with absolute return aims, says that there are indeed exceptions to the rule and that it depends on the fund’s mandate.
For example, if an absolute return fund has a consistently strong long-term track record and has what he deems to be a reasonable hurdle rate, it could still be worth considering.
Another factor that should be taken into consideration, according to the manager, is the percentage of the performance fee itself.
According to data from FE Analytics, 14 funds in the IA Targeted Absolute Return sector have performance fees of 10 per cent while double this have charges of 20 per cent.
“I think 20 per cent is far too high a share. I think 10 per cent is more than adequate. Ultimately it will depend on what the target of the fund is. If the fund is quite low-risk, then I think it’s quite hard to generate a performance fee because you’re taking too much juice out of the product,” he continued.
Table of absolute return funds with 10% performance fee
Source: FE Analytics
“It’s actually more appropriate for performance fees to kick in for higher risk funds where you’re looking to generate superior returns, and that can be applied an a relative or absolute basis.”
“In absolute return, I think if it’s targeting inflation plus 5 or 6 per cent and you still have that minimum hurdle rate in there then it’s probably okay. But on balance, if I had two funds side by side that I felt were of similar quality and one had a performance fee and one didn’t, I definitely wouldn’t buy the one with a performance fee.”
In an article published last month, the manager told FE that he is struggling to find many vehicles in the market area that he would be willing to buy, partially as a result of their higher ongoing charges figures in addition to performance fees.
He believes that the fact absolute return funds should charge higher fees than their peers because they are more complex is somewhat of an industry ‘myth’.
For instance, Coombs points out that his four crown-rated Rathbone Total Return and five crown-rated Rathbone Strategic Growth portfolios have clean OCFs of 0.86 and 0.91 per cent respectively.
“My funds are absolute return, we don’t charge a performance fee and OCFS in two of our funds are below 1 per cent. Of course it can be done,” he said.
“There may be a few more moving parts, but so what? The OCF is very reasonable because it doesn’t need to be more expensive. If you think back 10 years ago to when hedge funds wouldn’t let you see what’s in their portfolios and they were doing very clever things, I think we’re all a bit wiser to that now.”
“I think a lot of that mystery has gone and I think that we should look at absolute return funds in exactly the same way that we look at any other fund. I don’t see any reason for them to be more expensive and I don’t see any particular reason why they should justify performance fees.”
Charles Younes, research manager at FE, agrees that performance fees are unfair when it comes to absolute return vehicles that are simply benchmarked against cash or even lower.
For instance, he points out that a number of absolute return funds are benchmarked against the LIBID (London Interbank Bid Rate), which is LIBOR (London Interbank Offered Rate) minus 25 basis points. This means that some absolute return funds can still charge a performance fee without beating cash.
“I just feel like it’s completely unfair. You don’t even have to outperform cash in some cases and you’re charging a performance fee. I can understand why they’re using cash as a benchmark for a performance fee but with cash at that level I think there should be some measure of real return such as cash and inflation, rather than just cash,” he said.
“Even if inflation is very low currently, it should be not only cash but cash plus inflation. Now given the bond market story, it obviously depends on the strategy. A long/short equity guy can obviously benefit from a rising market so he should do well and, at the same time, if the market is falling he should protect the money. I’m fine with that.”
“You also have some strategies, such as global macro strategies, that don’t really care about the direction of the market. what they want to do is capture that rising market and they have to prepare for following and picking the right one at the right time. These are complex strategies.”
As a compromise, Younes says that management fees should be reduced for investment vehicles that charge a performance fee.
“We all know that performance fees are asymmetric payments – they are rewarded when they are outperforming the market but when they are failing to do so they’re not punished for it. We will always have this asymmetric payment issue but so far it is agreed by everybody,” he continued.
“Many absolute return vehicles are expensive strategies and I think for some, it’s unfair for them to compare themselves to cash, but higher fees do make sense for many of the strategies.”