Absolute funds make poor returns

Many absolute return funds failed to outperform cash last year, but after a healthy first quarter in 2007, the outlook is more positive and they are on track to reach their full-year return targets.

As reported in Fund Strategy (June 25, page six), not one absolute return fund rated by Standard & Poor’s (S&P) met its investment objective over the past year.

All of the funds fell short of their return targets after fees and most failed to outperform cash, according to the latest S&P survey on the sector.

Kate Hollis, director of fund research at S&P, says the main reason for the underperformance is the fixed interest processes it uses. She says at least 75% of the sector has fixed income-type processes.

However, Hollis points out that funds will not necessarily meet their targets every year. She says S&P does not rate funds unless it thinks they have the potential to outperform over time.

S&P says it is now more positive about absolute return fund performance in 2007. In the first quarter of this year, many of the S&P-rated absolute return funds have outperformed cash and are on track to achieve their full-year return targets.

In the AFI there are six absolute return funds: BlackRock Merrill Lynch UK Absolute Alpha, CF Ruffer European, Insight Diversified Target Return, JPM Cautious Total Return, Jupiter Income and Swip Absolute Return UK Equity.

The most popular of these is the £140m BlackRock Merrill Lynch UK Absolute Alpha fund. It is a new addition to the AFI, not having appeared in season five. The second most featured absolute return fund is the £4.18 billion Jupiter Income fund. However, it only occurs half as often as last season.

Jonathan Wallis, the head of retail fund research at Allenbridge Group, does not hold any absolute return funds in the AFI, nor does he have any on his wider advisory panels. He says absolute return funds tend to do better in volatile markets.

“They sound good in principle, but the numbers don’t really support the publicity that some of them have,” says Wallis. [Absolute return funds] are designed for markets when there is volatility. If you are in that situation, they could be the way forward. Many of these funds would have been built on markets [that] were quite volatile. [But] it would seem the market conditions have reversed. We do not have too much in the way of queries about them.”

David Wynn, investment director at Bentley Jennison Financial Management, is positive about absolute returns. He says they are “the way to go”.

“There is a huge place for absolute return mandates,” says Wynn. “[They were] more prominent in the institutional market and high net worth individual [sector]. It is more about taking risk off the table, than getting the market timing right. We are comfortable with the concept.”

However, Wynn does not hold any specific absolute return funds in the AFI. Instead he says he puts the portfolios together so there is reduced risk and more diversification. This, he says, is what absolute return is trying to do.

“We have put forward for the AFI a portfolio that will not be as volatile as a long-only equity mandate. The asset allocation is widely diversified. As a result, when [the funds] are put together, the risk reduces. It is all about having a diverse pool of assets.”

Wynn says the priority of his clients tends to be capital protection, rather than capital growth, and this is why he favours absolute return mandates.

“We offer [clients] the whole risk spectrum, but we tend to find [clients] want to protect capital [they have already built]. This is where absolute return is perfect for us. It protects capital through any market cycle. We definitely think it is the way to go. It is more appropriate than just holding long-only equity funds.”

Rather than use any particular absolute return funds in-house, Bentley Jennison gets discretionary managers to take on absolute return mandates. “We tend to use managers who are prepared to take on absolute return mandates,” says Wynne. “[But] there aren’t many of them around. Many long-only managers are not comfortable taking it on,” he adds.

With regard to the performance of absolute return funds, Wynne says it is not realistic to judge them over one year. “Absolute return should be measured over a rolling-three-year basis,” he says. “For a fund with a target of cash plus four, you will have times when the portfolio is under water.”

Shauna Bevan, investment manager at Charles Stanley, does not hold any absolute return funds in the AFI. She says one of the reasons is an optimistic view of the markets.

“We don’t use them [in the AFI]. They tend to be peripheral to [our] core strategy. Where we do use them is to reduce some of the overall risk. We have been reasonably optimistic about markets. If our outlook changed and we became less optimistic, we would use absolute return funds.”

Bevan adds absolute return funds are more likely to be used in the larger clients’ portfolios as an alternative to bonds. Charles Stanley has been negative on bonds for “quite a long time”, she says.

“Because [absolute return funds] are quite new, we have not jumped in. They do not have long track records. [Also], we are positive about [equity] markets. As the asset class matures, I could see us using them a bit more.”

The Adviser Fund Index series comprises an Aggressive, Balanced and Cautious index each tracking the performance of portfolio recommendations from a panel of 19 investment advisers. For each risk profile, all panellists specify a weighted portfolio of up to 10 funds from the authorised UK unit trust and Oeic universe that, when aggregated, define the constituents and weightings of the three AFIs (see www.fundstrategy.co.uk/adviser_fund_index.html).