Analysis-Absolute Return no refugee in stressed markets. By Natsuko Waki

LONDON (Reuters) – Investors who bought into “absolute return” funds hoping to make money in relentlessly turbulent trading are instead finding their capital eroded in markets that are making a habit of sudden mass flight from risk.

High correlation among different asset classes and shrinking liquidity are making life difficult for the $180 billion (114.8 billion pound)-plus absolute return funds industry, which unlike hedge funds has limited means to ride out volatile markets.

With some governments mired in the euro zone’s two-year-old sovereign debt crisis and some money market funds – also meant to be ultra-secure – under pressure from high exposure to the banking system, the choice of assets where investors can seek refuge is shrinking further.

Absolute return funds invest in a wide range of assets including equities and bonds and use derivatives like credit default swaps to dampen volatility and manage downside risks.

These funds have garnered interest after the introduction of a European regulation in 2001 that allowed a wider group of investors to gain access to hedge fund-like strategies. But they do have constraints on physical shorting of securities and command high performance fees, often stretching to double digits.

And their performance has been far from encouraging. According to Lipper data, absolute return funds denominated in the Swiss franc, euros and sterling lost on average 3.5 percent in the 10 months to end-October, compared with a return of 2.4 percent in the same period in 2010.

“Absolute return funds are there to dampen down downside risk but you can’t get everything right. The risk of return-enhancing absolute return funds is that you may have illiquidity and deliberate, unforseen, voluntary or involuntary leverage in them,” said Bill O’Neill, chief investment officer at Merrill Lynch Wealth Management.

“They may have more correlated assets and may prove more sensitive to markets than you think. They are for return enhancement, not pure capital preservation.”

A loss of 3.5 percent underperforms a pure index tracker fund investing in benchmark indices – S&P 500 index .SPX lost just 0.75 percent in the same period, worrying for investors looking for an alternative in times of market turmoil.

In Europe, flows into absolute return funds fell to 5 billion euros (4.3 billion pounds) in the first 9 months of this year, just three percent of total assets. This is a sharp slowdown compared with inflows of 27 billion euros in the whole of 2010, or around 20 percent of total assets.

In contrast, global bond funds attracted 16.7 billion euros in the same period, about 10 percent of total assets.

“If you are choosing absolute return funds you have to be careful. There’s no free lunch,” O’Neill said.

<^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^

Graphic on proportion of funds with positive returns link.reuters.com/tew24s

Absolute return funds sales in Europe link.reuters.com/xew24s

^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^>

LOSING SAFE-HAVEN STATUS

The worst performer among the funds is a euro-denominated mixed asset fund by Germany’s HANSAINVEST which lost a whopping 45 percent in the 10 months to October. On a five-year horizon, an absolute return bond fund in Isle of Man by Nedgroup Investments denominated in dollars lost more than 84 percent.

Among more than 1,000 absolute return funds tracked by Lipper in Europe, a positive 12-month return has been generated just over 65 percent of the time over the past five years.

Absolute return funds’ fate may be similar to money market funds, which lost their safe-haven status after the crisis.

Despite their image as an alternative to bank deposits, they “broke the buck” at the height the 2008/2009 market turmoil, where net asset value per share in some leading funds fell below $1, largely because of their exposure to the banking sector.

After all, absolute return funds are not guaranteed by regulators and can incur losses, unlike bank deposits or custodian accounts.

“If you look at absolute return funds, many of them don’t necessary deliver absolute return,” said David Miller, partner at Cheviot Asset Management.

“In this environment, safety is valuable and at a premium at the moment. Sometimes what is offered as safety is not necessarily safe. Investors have to be selective.”

RISK AND RETURN

As the universe of safe-haven assets narrows, investors are also confronted with real and nominal negative rates in some of the ultra-secure instruments such as top-rated government bonds and Swiss franc deposits.

This emphasises the point: one cannot achieve returns without taking some sort of risk. It’s the same for absolute return funds, so investors may lose money, but what these funds can do is to reduce the swings in value of your portfolio.

“Flexibility and risk management are the two largest benefits of absolute return funds. Risk is not driven by the composition of your benchmark but by a fund manager who can actively manage risks,” Valentijn van Nieuwenhuijzen, head of strategy at ING Investment Management said.

ING’s current absolute return strategy aims to return cash, measured by Euribor, plus three percent. It uses derivatives and CDS to manage downside risks and it is planning to launch another absolute return fund.

According to Nieuwenhuijzen, 50-50 equity/fixed income funds have annualised volatility of 3-14 percent in the past 10 years, while absolute return funds can achieve annualised volatility of around 2-8 percent.

“In principle, anybody who invests should understand the relationship of risk and return. The ultimate aim for a professional investor is to find the most attractive trade-off between certain risks and returns in the financial market,” Nieuwenhuijzen said.