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Changing colour of money

The investment landscape is changing rapidly. New funds are being introduced which could never have been promoted to retail investors in the past.

Some of the strategies used are not overly familiar to many IFAs but they will need to make themselves more aware of them because many more such products are likely to be launched.

Until recently, managers of UK retail investment funds could only make use of derivatives for efficient portfolio management but the publication of Ucits III and the FSA’s new sourcebook (Coll) mean that fund groups now have far greater flexibility in the design of funds. Managers have the option to use a greater variety of investment tools, including derivatives such as futures, options and contracts for difference.

Ucits III regulations do not permit short-selling of physical securities but do allow fund managers to create synthetic short positions as long as the exposure is covered by the fund’s assets.

Put simply, fund managers using the old rules can only avoid holding stocks that they think will fall in value but, if their funds adopt the powers available under the new rules, they will have the potential to make money from these stocks. Thus, it is possible to make money both in rising and falling markets.

Derivatives will often be used to reduce volatility rather than enhance the prospect of spectacular gains. The risk-reward trade-off is the prospect of less exciting returns for investors when the particular asset class underpinning the investment performs well, in return for the potential for positive returns in all market conditions.

For example, in a bull market for equities, a good long-only fund is likely to perform better than an equity fund taking up synthetic short positions because shorting will act as a drag on returns. Similarly, in an environment where interest rates are falling constantly, a traditional long-only corporate bond fund might perform better than a fixed-interest fund which invests in the bond futures market.

These differences in the likely patterns of returns between funds using derivatives and traditional long-only funds offer obvious and potentially attractive benefits of diversification when building portfolios. This could lead IFAs who want to make room for absolute return-type funds to consider re-engineering the asset allocation models they currently use.

Given the chameleon-like ability of these funds to transform by altering their mix of asset classes, including the potential to invest up to 100 per cent in cash, this may not be as easy as it sounds.

IFAs will also have to contend with some loss of transparency. Fund factsheets are unlikely to resemble the ones we have been used to seeing. Top 10 stock holdings immediately become much more difficult to provide when long positions are held in some stocks and other stocks are being sold short synthetically. Details of individual stock positions are also unlikely to be issued regularly to avoid the risk that a group’s competitors might try to move the market in the opposite direction to a man- ager’s open position.

Fund groups will clearly have to find a way of letting IFAs know what is going on inside these funds.

The use of derivative overlays involving interest rate swaps, bond futures and contracts for difference, as well as the potential for managers to use a mix of different asset classes within one fund, will make some of these funds sound almost incomprehensible to investors if IFAs try to explain them in detail. When dealing with clients, we will need to adopt a straightforward approach to describing their risks and rewards.

Talking of risk, despite the fact that derivatives are likely to be used to reduce rather than increase risk, the FSA is keen to see the funds that use them come with an above-average risk warning and rightly so. The vast majority of derivatives are “over-the- counter” securities structured by investment banks and are there- fore still subject to financial counterparty risk.

The use of derivatives to produce absolute return vehicles is likely to lead investors to put fund performance firmly in the spotlight. A fund that has a stated target return has a much more easily identifiable benchmark to measure its performance by.

There is also the potential for investors to see a fund’s target return as some kind of promise or guarantee of performance. IFAs will need to educate them to anticipate these sorts of return averaged over a three or four-year cycle and to expect performance to exceed or fall short of their target in the meantime. Even then, IFAs will need to lower investors’ expectations because a fund’s stated target return will often be quoted gross rather than net of management charges.

Given the performance from equity markets in recent years, the potential for stockmarkets to trade sideways and the fact that bond valuations now look rather stretched, the aim of the new breed of absolute return-type funds to generate positive returns in all market conditions is likely to sit well with the majority of investors.

However, IFAs still need to convince themselves that the managers they choose to invest with have the necessary experience and skills to run them.

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