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Absolute beginnings

There are so many different approaches to managing absolute return funds, which makes advice vital

Absolute return this, absolute return that. No one even slightly familiar with the ads gracing the financial press could accuse our industry of failing to react to a sales opportunity when they see it.

What is perhaps less evident is that there are some very different approaches being taken to the manage-ment of absolute return funds. The net result is that investors and advisers should give products a long hard look to make sure they do what they say on the tin.

The concept of an absolute return fund is intuitively attractive for many investors. Rather than investing to outperform an index, which carries risks if the market starts to fall sharply, managers of absolute return funds seek to produce a positive investment return, whatever happens. The same approach has been followed by private client wealth managers for years with great success.

Our analysis suggests that the recent raft of absolute return funds can be grouped into two categories – cash-alternative products and products which target a more ambitious rate of return.

As you would expect, cash-alternative products hold out the prospect of returns which are marginally above deposit rates accompanied by a low level of volatility. The first question that investors should ask is whether they would be satisfied with that rate of return. Such a fund might be a suitable substitute for the cash portion of a portfolio but prove disappointing if the investor was hoping for equity-like returns. Of course, while these funds might be “cash-like”, they are not cash-equivalent. Look closely and you will see that most of these funds carry some sort of risk to capital – something you do not get from a deposit account.

The second question is whether the fee level is justified on these products. For example, one fund holds out the prospect of delivering an annual return 2 per cent above building society rates but levies an annual manage-ment charge of 1 per cent. Not everyone would be attracted by the prospect of a 1 per cent return over society rates after fees.

At the other end of the scale, some funds target more ambitious rates of return, with volatility to match. Perhaps best viewed as suitable substitutes for equity or fixed-income investments, investors should match the risk profile of the fund against the part of the portfolio where they are intending to allocate it. It is important to be sure that like is being compared with like.

Before reaching a final decision, it is a good idea to look under the bonnet. Is the investment manager making full use of the investment powers available under Ucits III and associated legislation?

Derivatives can be held for investment purposes and not just to diversify away risk. Funds can also hold a net “short” position and generate a positive return in falling markets. Not every absolute return fund utilises these new powers but if they are not in the investment manager’s toolkit, perhaps a degree of flexibility is missing.

Another question to ask is how the investment returns are generated. Approaches differ wildly and even funds which offer returns barely above the bank deposit rate can use some surprisingly complex derivative products to aid in producing the investment return.

Common sense is the rule. Look at the investment mana-ger’s credentials, listen to what is being said and think twice about investing if you cannot understand where returns are coming from. Does this mean that investors should take advice before allocating to an absolute return fund? Absolutely.

Finally, remember that just because a fund is labelled as an absolute return product, there is no guarantee that investment returns will always be positive. An investment strategy can take time to generate the intended returns. As with any investment, investors should be prepared to take a long-term view.

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