Absolute Return Fund - Should You Invest in One?

You may have heard about Absolute Return Funds being launched and appearing in the press recently. We have seen quite a few of them launched in the last year or so, and they sound good don't they? Absolute returns - hmmm, let's investigate.

There are 3 main reasons why these funds have appeared on the radar recently:

Managers have only recently been allowed to use techniques such as shorting (see below) in retail funds. With stock markets down 40% in the past year (to the end of March) and some pundits predicting further falls, it makes sense (from the fund manager's perspective) to launch a fund that claims to be able to make profits for its investors even when share prices are falling. There is evidence from companies that there is an interest from the public in buying these products, and on the face of it, Absolute Return Funds profess to do what a lot of investors want, which is to make money and preserve wealth, in good times and in bad. We can certainly see a market for this! Heads you win and tails you don't lose. Of course, it would be fair not to hold them to this remit over every single time period. The essence of it is to deliver positive returns in almost all circumstances over time periods of, say, 3 to 5 years.

Ok, so far so good. But how can they do this?

The active management for this style of fund has been described as quite extreme. Fund managers are free to invest pretty much in whatever they wish, and are not judged against standard benchmarks because of this. Instead, they tend to be compared to each other.

It is common to use market timing techniques and changing exposure levels to different asset classes as they see fit.

One of the techniques an Absolute Fund manager will use is to 'short sell'. Effectively they borrow a stock from a broker who sells the shares and the proceeds are credited to the fund manager's account. At some point in the future, the fund manager must "close" this short by buying back the same number of shares and returning them to the broker. If the price has dropped, the fund manager can buy back the shares at the lower price and make a profit on the difference. However, if the price of the stock has risen the fund manager has to buy it back at the higher price and incur a loss.

Such flexibility is often associated with hedge funds and the very specialist fund managers. Of course, all this flexibility can come with a steep price to pay.

For example, on one fund we've researched, you'd have to pay a 5% initial fee to buy into the fund and then a 2.25% annual fee to compensate the fund manager. Alternatively, many of these funds have performance related charges whereby the fund manager takes, say, 20% of the gain they make above Libor (the interest rate banks charge each other) plus a 1.5% annual charge as well.

Another issue is the costs of trading (buying and selling shares) that active fund managers cannot really escape. In doing so, there are the costs to trade to take into account. These can add many percentage points to the annual cost of the fund, making it even more important for that fund manager to get their choices right.

The overall costs are therefore high, and can perhaps appear a little extreme and potentially soak up a lot of the potential profits. So as well as big promises, typical of this style of fund, come the high charges. However, if they deliver positive returns year in year out then this could perhaps be tolerated.

Let's look at performance.

We look here at periods of 1, 3 and 5 years, and show the average fund return as well as the highest and lowest. We then show two other sectors as a comparison over these time periods.

Absolute Funds

Years 1 3 5

Average % -0.1 6.4 49.1

Highest % 39.4 50.0 62.4

Lowest % -30.1 -36.5 -36.5

Funds Minus % 2 out of 16

Balanced Managed Funds

Years 1 3 5

Average % -13.1 -9.6 21.1

Highest % 9.0 38.0 121.6

Lowest % -33.6 -29.7 -8.0

Funds Minus % 5 out of 100

Emerging Markets Funds

Years 1 3 5

Average % -12.9 20.8 112.6

Highest % 4.3 47.9 155.0

Lowest % -27.3 1.5 67.5

Funds Minus % 0 out of 24

Source: Citywire performance tables August 2009

These are sectors we would not normally compare against each other. As you can see, you could argue that if the remit is to have less negative periods, then over 5 years the Emerging Markets sector would qualify based on these figures!

It is certainly a mixed bag of results for the Absolute Funds, and as you would expect, some do better than others.

So what is our opinion?

Regular readers of our newsletters will not be surprised to hear that we recommend ignoring 'fads' and sticking to tried and tested asset class investing. We recommend that you:

invest the right amount of money in the correct place according to the risks you wish to take and the time period you require. then allocate the money to the most appropriate tax efficient (wrapper) option buy at a low cost hold for the long term rebalance each year The Financial Tips Bottom Line

There are many investment options for you to choose from. Develop your own investment philosophy that will carry you through good times and bad, and resist the temptation to be blown off course.

Also, be aware of how costs can mount up, and that the more 'active' a fund manager is the greater the costs will be (which may not feed through to higher returns).

ACTION POINT

Take the time to review your investments and if you feel unhappy or unsure about any aspects of your portfolio, take action!