Choice name belies random results

The Absolute Return sector is saddled with a misnomer because its funds fail to do what it says it will. Investors should be cautious because it is a new category that has yet to establish a record.

If ever a fund sector displays what it should be achieving by way of performance for investors in its title, it must be ’absolute return’. Yet few other groups of funds have come in for so much criticism. As Seven Investment Management’s Justin Urquhart-Stewart once said, the trouble with absolute return funds is that too often they provide absolutely no return.

Rob Burdett, a co-head of the Thames River Multi-Manager team, also said that no funds in this sector had met their consistency requirements over the past three years. During periods of extreme volatility, risk control systems can force the managers to take action that damages short term performance.

”This sector is as much a lottery as any other”

This could explain why, over the past six months, the average absolute return fund has fallen 0.2% while the broader British equity market is over 2% higher.

Managers have defended their approach, pointing to the aim of producing consistent long-term returns with low volatility and accepting that periods of negative returns will occur. This can seem at odds with the aim of these funds, though.

This sector is relatively new. There are only three funds with a five-year record – Newton, Baring and Marlborough. Indeed, there are just 10 funds that have been around for three years or more and of the 41 funds that populate this sector, three have been launched within the past six months. (article continues below)

Of the 38 funds that have a six-month record, performance has ranged between Insight’s near 10% gain to a loss in value approaching 18% delivered by Octopus.

As with so many rapidly growing groups of funds with a similar investment aim, the Absolute Return sector has been driven by consumer demand. The volatile and unsettling conditions that were ushered in by the credit crunch led many investors to seek a more certain outcome for their investment assets. With the development of sophisticated trading systems and risk management tools, funds capable of delivering a positive return, regardless of market conditions, could be developed.

And so a steady stream of funds entered the marketplace to satisfy the demand for more predictable returns. The reality, of course, has turned out to be different. Looking at the variation in performance numbers, this sector is as much a lottery as any other. But if the range of management styles are, the different asset classes used and the variety of risk controls, perhaps the outcome should be less of a surprise.

Take the leader and the laggard funds over the short periods. Insight Absolute Credit is number one over six months and one year, where it recorded an impressive gain of more than 36%. Octopus trails over both periods, losing roughly the same amount on each occasion. Both describe themselves as long/short funds and use derivatives to manage their positions. Octopus is an equity fund, Insight uses bonds, both investment grade and junk, and other asset-backed securities. The difference in experience can only really be explained by the accuracy of the decisions taken, though.

The top fund over three years is also based on credit markets, but Henderson, which is the manager, also runs an emerging market debt fund with a thus far inconclusive record. The worst performance – down 8.6% – came from EFA Absolute Return, which describes its investment universe as a range of transferable securities, including investment trusts, collective investments, credit instruments and derivatives. No clue there as to why it has not done better over this period.

While many of the funds in this sector do not give any hint as to the underlying investments that go to make up their portfolios, some do. As well as Henderson’s emerging markets debt fund, there is a new one from Insight with an encouraging short-term performance.

Several are predicated on Europe, including funds from Gartmore, Legal & General and Liontrust. Gartmore also has a Japan fund and many are Britain focused. There is also a global option (Standard Life) while Skandia offers one devoted to Alternative Investments.

With such a range of choice the Absolute Return sector is as likely to encompass as wide a variety of outcomes for investors as any. Investors seeking a low-risk choice could be disappointed so advisers need to take proper due diligence before adding them to their armoury of investment products.

While the theory that these are low volatility, low correlation products that should offer a greater degree of certainty over the longer term may yet prove correct, the truth is that not enough of these funds have been around long enough to make proper judgments. It is therefore necessary, for the time being, to exercise caution.