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Absolutely fabulous?

The fund management industry has long relied on funds benchmarked against indices, with groups promoting the products generating the best relative returns. But this index-plus approach seems to be changing as a growing band of investment houses launch aggressive, concentrated funds which, at best, pay scant regard to index or stock weightings.

Gartmore, Merrill Lynch, Fidelity, JP Morgan Fleming, Threadneedle and Schroders, among others, all now boast focus or dynamic funds, many of which aim for absolute returns or, as with Threadneedle and Gartmore, punish underperformance with red-uced fees.

Insight Investment, when it announced its revamped inv-estment management structure last week, highlighted this shift, arguing that the fall in equity markets and bond yields has led retail investors to shun relative returns.

Chief executive Douglas Ferrans says: “Our acknowledged strength in investing against traditional benchmarks is now extended to reflect that our clients&#39 needs are changing. We are moving to a world of absolute returns.”

The appeal to retail investors of non-relative return funds is clear. According to research from Bates Investment Services, which says it has seen a major move towards concentrated portfolios, aggressive funds nearly always outperform their mainstream counterparts.

In fact, all 12 such funds it examined earlier this year had beaten their own group&#39s UK mainstream equivalent fund since launch.

Of those 12, Bates calculated that nine generated performance worthy of the increased risk inherent with funds holding less than 40 stocks.

Head of investments James Dalby says: “Dynamic or focus funds have not done as badly as funds that are benchmark-plus funds. The reason is that loosely benchmarked funds are good in all markets. If you think markets will move sideways for a while, then you need a good stockpicker. Index-constrained funds will simply follow markets up, down and sideways.”

Dalby believes groups&#39 reluctance to jettison traditional forms of benchmarking is due to a dearth of talented fund managers. Remove their benchmark, he says, and many managers will flounder, unable to cope without the safety net of index weighting.

Once this happens, reputations can be rapidly shredded and inadequate investment processes laid bare – the last thing groups need when they are struggling to maintain their shrinking funds under management.

However, another reason for this reluctance to move away from relative benchmarking is the problems associated with running concentrated funds. When launching its limited-issue fund earlier this year, Threadneedle made clear it was seeking investment only from fund of funds managers and those running discretionary portfolios – the minimum investment was £25,000 – while announcing that it would not allow the fund to pass the £100m mark.

The reason was lack of liquidity. When a fund has only 20 stocks, the chances of it being able to buy sufficient quantities of a company are slim when it has hundreds of millions of pounds to invest. But most other fund groups do not cap their funds even though there are a number of companies that believe they should.

Threadneedle communications director Richard Eats says: “How much of a firm can you buy? It is like asking an elephant to tap dance. Good luck to those with huge funds because they are hard to run. These focused products are attractive because of the higher returns on offer but investors need to understand the risk and the fact that there are as many of them in the fourth quartile as in the first.”

Eats says the fund industry has often promised more than it can deliver, especially in terms of suggesting that investors should buy funds they are unlikely to comprehend. He believes this will always be a problem, particularly when it comes to higher-risk funds, which is partly why Eats says Threadneedle is “very wary” of first-time investors with a loose grasp of risk and return.

Although many fund groups recognise the shift towards focus funds, not all are keen to enter the market. Henderson Global Investors, which closed its special situations fund in 2000, says there is still momentum behind the concentrated fund surge – which it suspects is marketing-driven in many cases – but believes there is evidence of a return to relative performance assessments.

Head of UK retail Simon Ellis says: “I sense that investors&#39 tolerance for index-plus funds has begun to return over the past six months. They are now making positive returns without having to massively outperform a falling index, so there is less need to take a risk with an alpha fund. The disparity in performance has narrowed.”

Ellis believes the way that groups assess and market funds is cyclical. He says the method most commonly used in the depths of the bear market – performance relative to cash – has less relevance now that the corner has been turned, leading to a shift towards performance relative to peer groups or indices.

Nevertheless, he expects more absolute return funds to launch in the coming months as groups become envious of the success, in terms of funds under management, of rivals that have made the move.

Chelsea Financial Services managing director Darius McDermott is one of many IFAs in agreement, noting that “performance tends to start trends”. But, as he points out, at a time when many investors are still licking their wounds and remain deeply reluctant to take risks, there can be only a limited market for high alpha funds, regardless of the marketing juggernauts driving their launches.

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