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Positive attitude

Investors will be painfully aware that most equity markets have fallen this year and it would be a brave man who suggests that we are now through the worst.

Fixed-interest investments have fared better than equities and yields are currently close to the levels at which they started the year. However, this masks some months of very high volatility, with bond prices being pulled in opposing directions by the weakness of the global economy and the rise in inflation. Given the huge amounts of money being pumped into the system to support stricken financial institutions, we expect the money supply – the root cause of inflation – to increase and put downward pressure on bond prices.

If both equity and fixed-interest investing are likely to be problematic over the coming months, what sort of strategies should investors be considering? Property is unlikely to be a solution, since the problems affecting the sector, including lower house prices and lack of available credit, are unlikely to be resolved any time soon.

One possibility is the commodities sector where the value of physical assets may rise as risk aversion adversely affects the value of less tangible assets. We have already seen a sharp recovery in the price of gold and the oil price seems ready to follow suit. This fits with our long-term positive stance towards commodities where we believe prices should be supported by the fundamental background of increasing demand and constraints on supply.

Another possible answer may be absolute return funds which are designed to achieve positive returns in all investment conditions. The managers of absolute return funds typically have greater flexibility than their market-relative counterparts and often use investment techniques unavailable to traditional managers.

These may involve using derivative instruments or taking short positions. Although taking short positions has been on the receiving end of some very bad press recently, it is not solely responsible for the collapse of the world’s financial systems, as is coming to be recognised. Properly used, it is a very useful process, enabling unitholders to profit when fund correctly identify overvalued securities, whether equities, bonds or currencies.

Some of the most interesting absolute return funds now operate in the fixed-interest environment, anticipating movements in interest rates and exchange rates. Many of these funds have built solid track records of producing positive returns that are uncorrelated to the performance of other asset classes. One of the key investment principles is to hold a balanced portfolio of assets with a low correlation to one another in order to achieve performance in different conditions.

A number of these funds are regulated under the Ucits III framework, giving them some advantages over hedge funds. While they share some of the characteristics of hedge funds, namely, the ability to take short positions and the aim of producing a positive absolute return, they benefit from lower minimum investment levels, lower fees and the security of operating within highly regarded regulatory jurisdictions.

To sum up, against a background of rising risk aversion and uncertainty, some traditional investment strategies run the risk of underperformance.

Advisers could find it worthwhile to consider the use of selected absolute return funds in order to generate uncorrelated positive returns. Those funds which anticipate the rise or fall of interest rates and the relative movement in the foreign exchange markets have developed strong track records over the past few years and are expected to continue to do so in the future.

Ian Pascal is marketing director of Baring Asset Management

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