Absolute returns might not be a safe haven after all

With the current economic instability, any private investor is bound to feel a touch of the collywobbles. Against this turbulent backdrop, one type of fund – absolute returns – is supposed to stand tall.

As the name suggests, these funds aim to generate growth in all market conditions by going beyond the normal fund manager tactic of selecting stocks for income and growth. Investments are hedged and managers have more freedom to spread investor cash across a range of assets. Although they aren't reaching for the stars, these funds aim to make at least some positive returns, irrespective of falling stock markets.

But there is growing criticism. Performance is decidedly second rate, particularly among some big-name launches. More seriously, ratings agencies and even the Financial Services Authority (FSA) has flagged the sector as a concern, sparking fears that absolute returns could be the next mis-selling scandal.

"Because there is no commonly agreed definition in Europe of what constitutes an absolute return fund, we see an increased risk that they could be mis-sold to investors who might not be aware that the funds only aim to outperform cash returns, rather than a stock market index, and that returns are not guaranteed," says Manuel Arrive, a senior director in Fitch's Fund and Asset Manager Rating team.

It can be a struggle to distinguish between the options available. Strategies can be complex, with managers using traditional investments in shares alongside financial instruments such as derivatives, which are specialised products enabling investors to bet on an assets' future price movement.

In a bull market, the risk is that these funds will underperform traditional equity funds, but for many, the assurance of returns year in year out is worth sacrificing such gains. But it seems much of the absolute return sector is failing to perform the basics of keeping pace with inflation.

In the year up to 31 July 2011, only 43 per cent of funds in the Investment Management Association (IMA) absolute return sector managed to beat even the lower measure of inflation that is CPI and deliver positive returns, according to Financial Express (FE) Analytics. "There is a perception that absolute returns are fine if they beat the rates available through a savings account, but what really counts is if they beat inflation. Otherwise you're getting poorer," says Pascal Dowling, investment specialist at FE.

Eleven funds out of 69 actually lost their investors money, and the poorest performers included Polar Capital's UK absolute return down 6.39 per cent, GLG's Alpha Select down 7.02 per cent, and IFDS's IM Octopus Absolute European down 7.72 per cent.

Investors also face high charges, with most fund managers taking annual fees of up to 2 per cent and a cut of positive returns. "Many have performance-related charges, with the fund manager creaming off an additional 20 per cent of the outperformance against a target. This 'hurdle' to qualify for an additional payment is usually set very low," says Martin Bamford from independent financial adviser (IFA) Informed Choices.

But not all is poor; FE Analytics figures show that some managers recorded impressive returns in the year to 31 July, with CF Odey's UK absolute return up 33 per cent, Cazenove's Absolute UK Dynamic up 30 per cent and GLG's Emerging Markets Equity up 22 per cent leading the way. Yet in one respect this sort of fantastic performance shows a fundamental flaw in the absolute returns sector. If the idea is to have funds delivering relatively constant positive returns without much volatility, what are investors and regulators meant to make of such a diversity in performance?

Advisers argue that there are so many different types of fund that to compare like with like is almost impossible. Even taking three examples of funds with a common theme will bring up significant clashes in terms of risk appetite, says Darius McDermott of IFA Chelsea Financial Services. He cites the Absolute Insight UK, the Henderson UK Absolute Return fund and the Cazenove UK Absolute Dynamic. "They are all in the same sector and use same tools, but I would suggest that they are three quite different funds," he says. "The absolute returns sector is a real mixed bag in terms of how the fund managers achieve their targets, how much risk they take and what tools they use to get to their targets."

Such a broad universe makes it even more difficult for investors to make the right decision, and the IMA is under pressure to establish subdivisions that will define the various types of funds and the strategies employed.