The recent drive towards investing in absolute return funds could lead investors down a road of disenchantment as many advisers foresee anti-climatic returns.Hargreaves Lansdown head of research Mark Dampier thinks there is a danger that clients will misunderstand the potential of absolute return funds. He says: “There is a huge potential market for these things but there is also a huge potential for disillusionment from investors and brokers alike and we just want to make sure that we get it right.” Threadneedle and Dawnay Day Quantum are just two companies which have recently launched absolute return vehicles. Dampier claims there is a “big ques- tion mark” over whether these funds will deliver and which ones will perform well. In his opinion, investors need two or three years to see how an absolute return fund will perform in a var- iety of market conditions. Bates Investment Services senior investment adviser Paul Ilott says these funds are really “get rich slowly and progressively” investment strategies and is worried that they will not live up to client expectations. He has devised a table to show how these funds would have performed in the mar- ket conditions of the past 10 years. The chart (below) compares the anticipated performance of an absolute return fund over the past 10 years with the performance of the average UK all companies and UK corporate bond funds. Using 10,000 as the investment amount, the chart illustrates discrete yearly performances. It assumes a target return of the six-month Libor plus 3 per cent a year – the same target return as JP Morgan’s cautious target return fund – net of charges and assuming the fund’s target return was met. The absolute return fund would have given an investor a return of 20,461 over 10 years to September 30, 2005 – 899 less than the UK all companies average return for the same period. Over three years from September 30, 2002 to September 30, 2005, the target return fund would have provided 4,400 less than the UK all companies average. Ilott says: “Actually, there would not have been a great deal of difference between the target return funds and the average UK bond fund. But whether that will hold out over the next three years is difficult to say.” Dampier says there are a number of reasons why these funds have become popular with investment companies. Following the publication of Ucits III and the FSA’s new Coll sourcebook, fund groups have been able to be more flexible in the design of retail funds. Managers have the option of using a variety of investment tools, including derivatives such as futures, options and contracts. Dam- pier says this has been a key reason for the growth of absolute return funds or target return funds as it takes a high degree of flexibility to run these funds. He also believes that, in the aftermath of the recent bear market, the attractions of returns above cash and absolute benchmarks are obvious to private clients. Dampier says absolute return funds will also be boosted by the boom in self-invested personal pensions, as investors want to make money without “losing it all five or 10 years later”. Yet the closure of the DWS Ratebuster plan is an exam- ple of what can go wrong with these funds. Dampier says: “In the first six months of Ratebuster, it did not make any money, so it is not a glowing start, is it?” Miton Investments fund of funds manager Sam Liddle thinks the DWS model had a good structure, in essence. “Unfortunately, the only deal they did was to bet against the dollar, which went completely the wrong way so everyone ended up basically getting their money back after six months. “It seems extraordinary that a company with these depths of resources, research capacity and so forth could make one deal and it was completely wrong. But the structure there was reasonably good,” says Liddle. The danger of these products, in Dampier’s opinion, is that clients will assume that Libor plus 2 or 3 per cent will be made every year but this is not the case in reality. He says: “Actually, it is just like running a benchmark against the All Share or something. It may be that in one year you make cash, next year you make cash plus 5 per cent and the next year you lose -1 per cent against what you would have received in cash.” Dampier quite likes the concept of the JP Morgan cautious target return fund, which aims for 3 per cent above Libor net of fees, but he is waiting to see its performance before making any decisions. The fund has returned 1.81 per cent over one month to September 30, 2005. Merrill Lynch UK absolute alpha fund manager Mark Lyttleton also believes there is a danger that clients may misunderstand the potential of absolute return funds. He says they should not be benchmarked against the index and investors should remember that they are not buying a long-only product. The UK absolute alpha fund, launched on April 29 grew by 3.88 per cent over three months to September 30. Lyttleton says: “The fund is up by just over 6 per cent to the end of September since launch although October has been a difficult month. We are not trying to make 50 per cent a year. We are trying to make decent absolute returns in whatever market conditions. “I think we have got quite a compelling story. People will take time and we know and accept that but the fund has grown nicely since launch without us really marketing it. There is no point in market- ing it until you have got some- thing to market so we have got a product but we do not have a long track record yet.” Dampier says he is not sure whether these funds are worth the extra risk. “You are looking for a big return on some of these before charges and that is what concerns me. It needs to have enough oomph in it to reach a minimum of cash plus 2 per cent because why would the private client want to take the risk otherwise?” he says. Nevertheless, Lyttleton thinks we will see more launches of absolute return funds and predicts that investors will become more interested in these products when they have a year where the market goes down by 10 per cent. He says: “The interest we are seeing is from a number of places. People are looking to diversify their long-only type of business into something that is still equities a and can still make you decent money if the market goes up but will also make you a bit of money if the market goes down as well. “So it is quite a nice risk diversification.