Absolute return funds should be part of diversified portfolio to mitigate risk, according to Darius McDermott, managing director of Chelsea Financial Services. 
While many bemoan the relatively high fees, most still agree that a good absolute return fund should be used to anchor a portfolio, particularly in a world of historically high bond and equity valuations as well as growing macroeconomic headwinds.
“The sector is very diverse so you do need to research it thoroughly, but there are some very good [absolute return funds] to be found and they have a role to play in a diversified portfolio, especially at a time when the fixed income market is so artificially distorted by central bank policies,” McDermott (pictured) said.
Meanwhile, the uncertainty following the EU referendum and the timing of when article 50 will be triggered, as well as the upcoming general election in the US and the Italian referendum this year have all left investors looking for security over recent months.
Performance of indices in 2016
Source: FE Analytics
With bonds providing historically low yields, risk-averse investors have been forced into defensive equities to find an acceptable future return, but this trend cannot last forever and McDermott lists three absolute return funds that investors should look to add stability to their portfolio.
McDermott’s first choice is the £1.7bn Henderson UK Absolute Return fund, run by FE Alpha Managers Ben Wallace and Luke Newman.
The five crown-rated fund has been less volatile than government bonds and equities over three years, while returning 18.81 per cent, just 20 basis points behind the FTSE All Share as the graph below shows.
Performance of fund versus indices over 3yrs
Source: FE Analytics
The fund is designed to provide investors with some security in times of economic difficulty, as evidenced earlier this year when it remained steady following the EU referendum result, while the FTSE All Share lost 5.35 per cent over the course of a week.
McDermott said: “Strict limits are placed on the overall market exposure, which serves to reduce the volatility of the fund (around a third of the volatility of the UK stock market).”
"It's a long/short UK equity fund with two thirds of the portfolio in shorter-term tactical ideas, where the managers believe an earnings surprise could be imminent.”
“The remainder will be in core holdings, where they think there are long-term drivers in place that will either increase or decrease the share price over time. “
The fund differs from many of its peers in the IA Targeted Absolute Return sector as Wallace and Newman use short selling stocks as a ‘profit centre’, rather than just shorting indices as a hedge against risk.
This strategy worked particularly well in 2015 when stock dispersion increased in the UK, with Henderson UK Absolute Return being one of the best performing UK funds with its double-digit gains.
Aviva Investors Multi-Strategy Target Income
Another of McDermott’s recommendations is the £1.5bn Aviva Investors Multi-Strategy Target Income, run by Brendan Walsh, Ian Pizer, Nicholas Samouilhan and Peter Fitzgerald.
The fund’s concept was put together by Euon Munro, who previously worked on the highly popular Standard Life Investments Global Absolute Return Strategies fund (GARS) and, the managers are aiming to deliver a steady income whilst seeking to preserve investor capital.
“This is one of very few absolute return funds to pay a decent yield (it targets annual income of 4 per cent above the Bank of England base rate), which is also paid on a monthly basis,” McDermott said.
“It gets its income from diverse asset sources and has a big emphasis on risk reduction and preserving capital during market sell-offs.”
Performance of fund versus indices since launch
Source: FE Analytics
The fund, which currently yields 4.7 per cent and has an ongoing charges figure of 0.85 per cent, has returned 7.83 per cent so far this year.
The Aviva Investors Multi-Strategy Target Income fund has been much less volatile (4.48 per cent) than gilts (8.67 per cent) and equities (10.34 per cent) and has a much lower maximum drawdown – the most an investor could lose if buying at the very top and selling at the very bottom.
BlackRock European Absolute Alpha
The smallest of McDermott’s suggestions is the BlackRock European Absolute Alpha fund, run by Vincent Devlin and Stefan Gries.
“This fund is designed to provide positive returns in any market condition and it has done: producing nice steady annual returns of just under 5 per cent since its launch in 2009, with less than a third of the volatility of European stocks,” he said.
Like the Henderson fund mentioned earlier, it is a long/short fund aiming to make a positive return over a 12 month basis.
Performance of fund versus index since launch
Source: FE Analytics
The £113m fund has returned 40 per cent since its launch in March 2009, and has made a positive return in each calendar year apart from so far in 2016.
While this means the fund’s returns since inception are significantly lower than the gains from the MSCI Europe ex UK index, the chart above shows how smooth the ride has been for investors in BlackRock European Absolute Alpha.
Indeed, its maximum drawdown over that time has been just 5 per cent (compared to 30 per cent from European equities) and its annualised volatility has been 3 per cent (compared to 19 per cent from the index).
