Easy pickings in current market not guaranteed

With market volatility likely to continue this year, absolute return strategies should offer the perfect panacea to market fluctuations.

The concept of a fund that generates positive performance - or in the case of target return funds, a cash plus type return – whatever the weather is particularly appealing in today’s uncertain climate.

Unfortunately for investors, absolute return funds do not always do what they say on the tin and many funds have so far failed to produce the positive returns promised. A recent snapshot of the 32 funds that sit in Trustnet’s onshore Absolute Return sector, a third lost investors’ money over 12 months to January 20, while over six months two thirds are nursing losses.

This mixed bag of results highlights how critical it is investors understand how a fund’s underlying engine works and, crucially, who is at the controls. While the use of complex instruments like futures and options can prove a useful performance booster in the right hands, their inclusion in a manager’s investment remit does not provide a return guarantee.

Investors also need to be aware of the wide spectrum of funds that fit within the absolute return category. The introduction of UCITS III rules may have given managers the scope to use derivatives and employ techniques such as shorting, but not all funds that fit under absolute return use them. This means different funds will have different risk profiles, depending on how they use these instruments.

Equally, fund groups may define absolute return differently, affecting the ways they try to achieve their investment aims. For some, absolute return means generating a positive, non benchmark-led return each year, for others it means meeting a return target, usually a few per cent above cash. With the latter, what cash benchmark the manager uses can also affect return expectations, while some targets are more realistic than others.

“The whole definition of the target v absolute is tricky but in general if it is targeting a cash plus type of return then I call them target,” says Darius McDermott, managing director of Chelsea Financial Services.

“If they are trying to give a positive return every year then I call them absolute.”

Other funds are considered hybrids. The Insight Diversified Target Return fund, for example, aims to produce a positive return each year but also hopes to meet a target of cash plus 4% over a cycle. The fund is multi-asset, with 60% of the portfolio outsourced to third party managers. The rest of the fund is invested directly in property stocks, commodities and currency.

Patrick Armstrong, Insight’s co-head of multi-manager, says the fund’s unconstrained nature has enabled the team to pick an eclectic group of fund managers, each with different skill sets and performance drivers.

“The beauty is many of these managers have very low levels of correlation with each other, and this helps us reduce our portfolio risk,” Armstrong says.

The fund has produced 7.1% over 12 months to January 20, a figure Armstrong says he is happy with, particularly on a risk-adjusted basis.

Absolute return funds also vary in terms of what region or assets they invest in. For example, several funds in Trustnet’s Absolute Return sector invest solely in Europe or the UK, others invest globally. Some invest in a range of assets such as equities, bonds and cash, while others stick to one asset class.

Scottish Widows Investment Partnership (SWIP) runs one of three absolute return bond funds launched onshore in the past couple of years.

SWIP’s Absolute Return Bond fund has the option to go short on markets by using derivatives, up to 100% of the net asset value of the portfolio, to help it achieve positive returns each year, although it says it has not yet exploited this option much. The result of its approach is steady performance of 3.1% and 6% over six months and one year respectively to January 20, although, as with many of these new funds, it will need a three year track record before investors are fully convinced.

“This strategy has proved adept at achieving a positive return in what has been a period of extreme market volatility for bond investors and has delivered a higher return than investors could have achieved in cash and government and corporate bonds [in 2007],” a SWIP spokesperson says.

The Threadneedle Absolute Return Bond fund has also produced positive performance, returning 10.5% and 9% over six months and one year. In contrast, UBS’s Absolute Return Bond fund is down 8.2% and 8.4% over the same periods, highlighting how varied returns can be from a sector that should offer a solution to today’s turbulent times.

1 February 2008