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Degrees of latitude

In volatile markets, private investors want access to a product that maximises returns while limiting downside risk. Is such a thing possible? I think it is.

Over the last 10 years, the investment management industry has become polarised. At one extreme, fund managers slavishly follow an index, terrified of deviating from their chosen benchmark by a fraction of a percentage point. This approach may be appropriate for an investor with a long-term investment horizon, such as a pension fund, but for private investors it fails to minimise losses when an index falls in the short term.

At the other extreme, there has been an explosion in the number of hedge funds seeking absolute return targets that are unconstrained by any form of benchmark whatsoever. Many of these hedge funds are extremely opaque, often using derivatives instruments to leverage their positions, which leaves people with little if any idea as to what they are actually investing in.

Faced with such choices, the poor old private investor can sometimes feel like he is caught between the devil and the deep blue sea.

But what if you could design an investment vehicle for private investors that followed a benchmark yet had far more latitude to deviate from it than a traditional active product? Total return funds, which are a relatively new phenomenon in the UK, are designed to achieve exactly this. They manage money on behalf of clients who want to achieve capital growth relative to a benchmark while preserving capital over a short-term time horizon. In this context, they define total return as an investment fund&#39s absolute return rather than its return relative to a benchmark.

The key to achieving this objective is to have a very active asset allocation policy in which a portfolio&#39s asset allocation may be changed very rapidly and regional or sector positions built up or unwound quickly and efficiently.

How would this work in practice? Well, one approach might be to encourage funds to follow a benchmark index but allow them to deviate from it significantly either by increasing or decreasing the allocation to equities, bonds and cash when the occasion demands. This enables funds to add value by exploiting movements between different asset classes and different regional equity markets.

It also enables them to preserve capital in periods when world equity markets are falling by transferring more of their assets into bonds and cash. For instance, if a fund thinks the outlook for equity markets looks particularly bad, it can reduce its allocation to equities to practically zero.

So what is the short-term outlook for equity performance? Most observers agree that an economic slowdown is already under way in the US and that the rest of the world will be affected but they are uncertain as to whether the slowdown will result in a soft, rough or hard landing. A hard landing, of course, would be negative for equities.

However, we believe there will be a soft landing in the US because liquidity levels are improving, short-term interest rates are being reduced and the new Republican administration is preparing to cut taxes. Moreover, oil prices have declined sharply from their peak last October and some of the benefits of this reduction are about to be passed on to consumers.

In Europe, where recent economic growth has been less spectacular than in the US, the effects of an economic slowdown are likely to have less impact, whatever form it takes. This is because consumer confidence remains high, wages are rising and recent data indicates the European unemployment rate has fallen to its lowest level since 1991. Any reduction in external demand should, therefore, be more than compensated for by an increase in domestic demand.

As a result, we expect European growth to hold up better than in previous global downturns and European stockmarkets, at least in the short term, to outperform US ones.

However, the long-term outlook for equities generally, while remaining positive, looks decidedly less rosy than it did, with many commentators predicting single-digit returns over the coming year.

Between 1995 and 1999, world equity markets went up on average by 14 per cent a year. During this period, it seemed that all you needed to do to make money was invest in equities. But, now we are in more uncertain times, it seems less appropriate to follow a benchmark, particularly if you have a short-term investment horizon.

Stockmarket volatility looks set to continue, not least because we can all trade more quickly and efficiently than at any time in the past and this has made us more active in terms of investment activities. In such an environment, total return funds come into their own.

Most funds offer the private investor either growth or capital preservation – rarely do they do both but the aim of total return funds is to deliver return regardless of whether the markets go up or down.


Julian Gibbs

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