Many Absolute Return Funds Fail to Deliver By Elaine Moore

Absolute return funds look set to remain a popular choice among investors seeking security in volatile markets – with more money than ever forecast to flow into the sector this year.

According to Fitch Ratings, the £23bn fund sector will continue to grow in 2012, in spite of disappointing performance in 2011.

However, financial advisers are expressing concern over investors’ enthusiasm for these funds, and their understanding of the likely returns.

Earlier this month, consumer group Which? included absolute return funds as one of its “financial products to avoid” – along with mobile phone insurance and payday loans. It argued that the objective of these funds – to produce positive returns in any market conditions – was simply “too good to be true”. Even if this objective is met by some funds, investors still might not understand exactly what they are getting into, according to the Financial Services Authority. The regulator has warned that some consumers may not be aware of the complexities of the sector – and might think the funds are guaranteed to protect their money.

In fact, absolute return funds simply aspire to achieve a return above zero.

Unlike other sectors, the funds are defined by what they try to deliver, rather than what they invest in, and can set their own targets rather than trying to match a benchmark index.

Their attraction is that they aim to provide a positive return even in falling markets, using a variety of techniques – including short selling stocks, to make a profit when share prices drop.

In theory, this should mean that their performance is uncorrelated with the wider stock market, and that they should be able to generate returns in markets that are flat or declining.
Sector is a misnomer, say analysts

The variety of investment strategies employed by absolute return funds makes it hard for private investors to distinguish between, and judge their performance, according to analysts.

A number of advisers and campaigners are now calling for the absolute return fund sector to be redefined and renamed – to make it more obvious what the funds invest in and the levels of risk and return investors can expect.

The Investment Management Association (IMA) created the Absolute Return sector just under five years ago – before many of today’s funds existed – and is now in the process of reviewing how it works.

This unusual state of affairs is, according to Jane Lowe, director for markets at the IMA, not ideal.

Rather than defining the sector by the asset class the funds invest in, the IMA defines them by their output, and their stated aim to achieve a return above zero.

But while the funds share the same aim, their managers employ a wide range of investment techniques, use different assets and benchmarks, and display varying risk characteristics.

These variations make it hard for investors to know whether the performance of one fund manager is better or worse than another – or whether the particular areas in which one manager invests is responsible for outperformance.

The IMA says its current review aims to ensure that performance comparisons can be made, but no one is yet sure that this will mean.

Some are lobbying for period in which funds are required to achieve a rolling return to be lengthened. Others hope for a new benchmark to be set. Some favour a split within the existing sector. A few believe the sector should be left as it is.

One member of the IMA Sector Committee has said that splitting the sector into three or four sub sectors could make sense. This division could separate out funds with an equity bias, those with fixed income bias, and a wider group that incorporates the rest. A decision from the IMA is expected in late summer this year.

But Meera Patel of broker Hargreaves Lansdown, questions whether classifications will solve anything. “The key thing to highlight is the disappointing performance of the sector,” she argues. “Not the description.”

But, in practice, the sector failed to meet this aim when equity markets become highly volatile in the second half of 2011. Figures from the Financial Services Authority show that more than half of the funds in the absolute return sector failed to provide a positive return in 2011.

Once inflation is taken into account, just a handful managed to provide investors with any real return.

“The fact that the performance of a fund in the sector isn’t blowing the lights out is acceptable,” says Ed Moisson of data provider Lipper. “But the fact that many funds are failing to generate a positive return is not. And there are only a handful of funds that manage to generate a return consistently.”

In the past year, a small number of funds have provided investors with positive returns, including the Insight Absolute UK Equity Market Neutral fund, Henderson MultiManager Absolute Return fund and BlackRock European Absolute Alpha, which is up close to 12 per cent.

But the roll call of funds with less impressive returns is far longer. “Returns have been all over the place,” says Meera Patel, investment analyst at Hargreaves Lansdown. “2011 should have been an ideal year for this sector. There were a lot of opportunities for them to employ their techniques and thrive, but many have not.”

Forty funds in the sector have lost anything from 0.1 per cent to 20 per cent of their value in the past 12 months, she explains.

Although absolute return funds should move in the opposite direction during market downturns, many funds appear to have remained closely correlated with the stock market.

Some financial advisers complain that the broad scope of funds in the sector makes it hard for private investors to gain a clear idea of exactly what they are putting their money into.

“The funds within this sector all do different things, which means that taking the sector as a whole and looking at its average is dangerous,” warns Patel.

Over the past three years, returns have been even more variable. They range from a rise of more than 40 per cent from Henderson Credit Alpha, to a decline
of close to 20 per cent from the SVM UK Absolute Alpha fund.

Like Moisson, Patel agrees that investors should not expect stellar, double-digit returns from a sector that is simply aiming to provide a positive return. However, she also agrees that investors should not have to accept repeatedly low results.

Others add that investors should not be expected to pay above-average fees for funds that fail to perform.

Fees charged by absolute return funds have been widely criticised as complex and expensive. Many fund managers charge performance fees on top of annual management fees – and award themselves the performance fee for achieving returns that beat cash.

Nor are fees consistent. While the Standard Life Global Absolute Return fund, which has risen more than 35 per cent in the past three years does not charge a performance fee, some funds with a less impressive performance record do.

Edinburgh-based SVM Asset Management’s UK Absolute Alpha fund has an annual charge of 1.5 per cent plus a 20 per cent performance fee if the manager can achieve returns above 3-month Libor, the interbank lending rate.

This performance fee kicks in quarterly, which means that the manager can take an extra cut if the fund performs well for three months even if it subsequently underperforms for the rest of the year.

Patel believes this “quarterly crystallisation” process is unfair. “We believe crystallisation should take place over a much longer period – at least three years,” she says. SVM declined to comment.

Another fund, Man AHL Diversity – an offshore fund available to UK investors – takes a 20 per cent performance fee on any positive returns that the fund makes, on top of an annual management charge of 2.75 per cent. However, since its launch the fund has failed to make a positive return.

Patrick Connolly, of financial advisers AWD Chase de Vere, finds it hard to draw a conclusion about the sector as a whole because of the differences between the funds in it.

“Some are equity focused, some bond, some use hedge fund techniques, others are little more than multi-asset funds, so the level of risk from fund to fund can be significantly different,” he says.

One of the few funds within the sector that he recommends is the Newton Real Return fund – a large, diversified multi-asset fund. The rest he steers clear of.

“If you look at overall returns, many of the funds don’t outperform cash,” he points out.

“So if capital preservation is your priority, then you should probably be looking at cash rather than exposing yourself to the volatility of this sector.”