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Bearing up in volatile markets

Volatility in global markets has caused some concern this summer but losses in open-ended funds have been somewhat subdued compared with those in the down years of 2000-03.

The average unit trust or Oeic has fallen by 0.1 per cent over one month and by some 4 per cent over three months to August 31, according to Trustnet. That said, just 300 out of a universe of some 2,100 funds recorded gains over the summer period.

With any general falls experienced in the market comes the fear that this will turn into the next bear market. It is at times like this that the attributes of total return funds are pro-moted. But what consti-tutes total return and how exactly does its presence today differ from other stages in the past 20 years?

Lessons learned from the prolonged bear market at the beginning of the decade have meant there is a greater focus today on total returns and, as such, managers appear more willing to incorporate downside protection techniques within their funds. On the surface, this seems a positive development but it also means the fund landscape today looks a whole lot more complicated.

Total return is not exactly a new concept to this industry and neither is the use of derivatives to provide some form of limited downside within funds. Investment industry specialist Stuart Alexander recalls that at one time there was a trend towards 90/10 funds, with one of the first launched by Gartmore just ahead of the 1987 market crash. Alexander explains that these funds offered 90 per cent exposure to cash and 10 per cent invested in a high-return strategy like a call option which could conceivably ratchet up any market gains.

But the timing of their introduction, before the 1987 market fall, meant that 90/10 funds were not a popular choice among investors. When the market did drop dramatically, most felt it was too late to buy such protection, Alexander notes.

Bear funds launched by Govett (and eventually owned by Gartmore until their closure not too long ago) and portfolios like the Close escalator funds with quarterly lock-ins were other incarnations of protected portfolios over the recent past.

Outside of designated protected funds, there have been a few managers over the years, particularly through 2000-03, that have used quite aggressive defensive strategies within their funds, like cash weightings in excess of 40 per cent. Probably the best person known for using such a strategy was former Odey European manager Hugh Hendry. Also at that time, some managers used instruments such as gold as a defensive measure. Most notably, it was reported that former Fidelity American manager John Muresianu adopted such a strategy at one point.

In retrospect, these measures look clever but fund rules at the time restricted such actions, with cash weightings limited to a maximum 10 per cent in open-ended funds. Regulations did allow amounts above that percentage on a temporary basis but it was still generally a frowned upon practice. The main argument against such a manoeuvre was that investors buy an equity fund so their money is invested in the market, not sitting in cash.

It is fine being on the right side of such an aggressive call but being on the wrong side means investors are essentially paying 1.5 per cent a year for a cash portfolio and could potentially miss out on rises in the market.

That does not appear to be the argument today when looking at the new breed of total return funds. Having been through a prolonged bear market, investors and providers alike seem keener on defensive capabilities within funds. New rules and regulations in the form of Ucits III make it easier to adopt such strategies within portfolios as well, enabling the broader use of derivatives, high cash weightings and the creation of mixed asset portfolios of equities, bonds, property and commodities.

The problem with this now is that there are many different ways in which managers can and are using these powers to enact protective measures. This has made an adviser’s job extremely difficult in determining and monitoring who is actually doing what and when.

All open-ended funds today fall under Ucits III or non-Ucits retail scheme rules but not all of them have adopted the full powers allowed under such regulations and those that have written them into a fund’s prospectus may not actually be using them – they are simply written in for the eventuality that they may be adopted at some point.

On top of this, the way that derivatives or mixed assets or cash weightings are used also varies widely. Some fund managers write options simply to add an extra stream of income to a fund, some use them to short stocks, sectors or entire markets while others are looking to derivatives for protection against potential market falls, similar to the way it was reported that Fidelity’s Anthony Bolton and Gartmore’s Gervais Williams did in recent times when they each bought a put on the index – a kind of insurance against market drops.

Sarasin Chiswell has a range of Ucits III funds that use the powers to provide limited downside protection in the funds. Deputy chief investment officer Paul Cooper says as more funds adopt Ucits III powers, there could be a problem with investors not really knowing what they are buying.

Cooper says: “There is a strong danger of this type of product being missold. It is a completely different breed of fund. Ucits III can give you as much opportunity to lose money as to make money and, like hedge funds, not everyone running these types of funds has the ability to do so.”


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