The advent of UCITS III in 2002 heralded the arrival of the absolute return fund, allowing fund managers to make use of derivatives.
Through using derivative instruments the managers are now able to give a hedge fund effect to their funds in that they can short stocks, although they are not allowed to gear up their funds borrowing against their assets as hedge fund managers can.
The trend for launching this type of fund shows no signs of abating at the moment.
“I know from around the industry that there will be more funds of this type coming in,” comments Merrill Lynch’s director of products and client strategies Tony Stenning.
In fact Merrill Lynch has just launched a target return fund, which is a similar product but one which has a published aim for what the fund manager expects to achieve.
Other funds of this type include the CSAM Target Return fund and the Baring Directional Global Bond Trust, which has quite high targets of three month Libor +4pc per annum, which manager Colin Hart is expecting will be made over the three year period.
In July Scottish Widows Investment Partnership (SWIP) launched three absolute return funds based on bonds, equities and a mix of asset classes.
“We launched the funds for a couple of reasons,” explains SWIP’s director of sales and marketing Andy Frepp. “Work we’ve done says that investors are telling us they’d like capital not to go down and to beat money in the bank.
”The other thing you want is a more diversified portfolio, and that issue has come to the fore; but in both situations things have shifted away from people having investments in just equities.”
Bonds or equities?
The market has expanded to offer bond absolute return funds as well as equity based ones.
Threadneedle runs the UK Absolute Return Bond fund and head of product development, Lothar Mentel, thinks that an investor who would normally buy bonds can add a fillip to his portfolio with an absolute return bond fund.
“In the bond world if interest rates go up you lose money,” says Mentel. “With a bond absolute return fund you can turn that on its head. If you know bonds aren’t going to be exciting for a while this sort of fund doesn’t have to lose money.”
However he warns that it is vital to know with any absolute return fund what risks the manager is taking with the derivatives he or she is using. The Threadneedle fund has a target of cash plus three percent, but is willing to risk plus or minus four percent to get to that.
“In an equity fund their instruments may be more volatile and they may have a risk of plus or minus more like 8pc,” Mentel observes.
Investor confusion
Consumers knowing, or not knowing, what goes on under the bonnet may be one of the reasons that absolute return funds have not had the most spectacular reception from the market since they were launched. Merrill Lynch UK Absolute Alpha was launched in May 2005 and still stands at just £70m.
Threadneedle’s product, launched in October 2005, has around £20m in it.
“This is a new-ish area for the private investor,” comments Mark Hinton, investment manager with Bestinvest. “The products can be confusing and sometimes the names can be misleading.”
The complication of having a different and new type of asset under the bonnet aside, absolute return sometimes doesn’t mean whatever the manager can get.
As with the Threadneedle bond product, it may be more that the manager is targeting a certain return within certain risk perametres.
The Merrill Lynch fund is going after the best it can make: “Mark Lyttleton aims to just generate positive return,” says Stenning. In a rising market the hedging components might hold the portfolio back against pure equity funds, as the portfolio is not all invested for an up market, but in a falling market this type of product should do better than its long only counterparts.
The ‘relative sandwich’
Recent markets are also partly responsible for less interest in absolute returns. “When you have a mini bull run as we saw last year people ask whether they need absolute return funds,” says Stenning.
The products will have their day, according to Hinton. “It’s a bit early to say how sucessful they are going to be, but I’m sure there will be more launched,” he explains.
If an investor holds the view that markets are looking good at the moment they may well just stay within their long only funds. “However,” says Hinton, “If you think markets might be volatile or down, you’re who these management houses are trying to capture.
I think these funds will bring money in to the houses that launch them because in the generally low return market we’re in its all about making some return, not just beating a benchmark that is making a loss.”
Merrill Lynch has faith in the future of absolute returns for the same reason. “Ultimately it is about getting back to basics and making returns for people,” says Stenning.
“You can’t eat a relative sandwich.” An absolute return fund will be much more welcome when markets are down 20pc and a manager such as Lyttleton has made 5pc, compared to a long only manager having lost ‘only’ 10pc, he explains.
The launches from SWIP and other upcoming houses underline the fact that fund management houses and their product developers like Mentel and Stenning see both markets going down at some point and investors wanting a portfolio which can roll with the punches a bit more.
Frepp points to both the institutional world and the retail market in Europe, where absolute returns is a growing trend.
“The reason for us launching now is we have decided this trend will exist,” says Frepp. “It’s a long process to educate people on this type of fund, and the danger in it is that they could be here today gone tomorrow, but we don’t think that is the case.”