The absolute return sector is one of the newest and fastest-growing Investment Management Association fund categories, having expanded from 17 funds when it was set up in 2008 to 69 today. Of those, 13 have launched since the end of June 2010.

Its appeal is self-evident: in the face of the financial crisis of 2008, with returns from long-only funds obliterated, nervous investors and advisers were easily seduced by the attractions of funds promising the preservation of capital and positive returns in all market conditions. Even as the market recovered, the inclusion of a ready-packaged hedge against further falls became a key element of many balanced portfolios. 

But this sector is also one of the more controversial in the IMA stable. That’s partly because many of its member funds don’t appear to be terribly successful in meeting their mandates. 

The sector definition stipulates that funds housed there should deliver positive returns over a 12-month period. Typically, absolute funds have as their stated aim beating cash returns by a few percentage points over that time, which in the current rock-bottom interest rate environment might be considered a relatively modest aspiration.  

However, new research from FE Analytics shows that 11 absolute return funds ended the 12 months to 30 June in negative territory. A further 18 delivered positive returns but underperformed the Consumer Prices Index, standing at 4.2 per cent in June. Investors in all those funds – which amount to 52 per cent of the 56 funds with a 12-month track record – would have lost money in real terms. 

Only 24 of the 56 funds – 43 per cent – beat the broader Retail Prices Index at 5 per cent. As Michael Holland, managing director of FE, observes that, although absolute return funds don’t promise to beat inflation, it’s ‘something investors must bear in mind if they want to preserve their capital and grow their wealth in real terms’. 

The conclusion drawn by FE is that ‘fund selection would have been paramount over the past year’ for absolute return investors. But comparisons are a real challenge because the sector has attracted a broad cross-section of funds, investing in different assets, operating very different strategies and embracing widely differing levels of volatility, as well as a number of fund managers who are simply not getting it right. 

Unlike many other IMA sectors, absolute return funds are categorised according to the objective of the funds – 12-month positive returns – rather than the assets in which they invest. So funds in this sector may hold anything from UK equities to emerging market debt, currencies or multi-asset portfolios.  

‘The sector is a complete mess of very diverse funds,’ says Mark Dampier, head of research at broker Hargreaves Lansdown.  Moreover, he adds, many are adding insult to injury by charging substantial performance fees for mediocre returns and cash benchmarks. ‘It, of all sectors, really needs to come with a big health warning that investors need to look under the bonnet of any fund they’re considering.’ 

A number of funds in the sector (including BlackRock UK Absolute Alpha and Insight Absolute UK Equity Market Neutral) are market-neutral vehicles in the mould of old-fashioned hedge funds, with a core long holding of equities or other assets balanced by short positions to counter adverse market movements. The aim is to produce positive returns equivalent to cash plus 2 or 3 per cent each year and minimise volatility in the process. 

‘These funds will use stop losses and other tools to protect capital,’ explains Darius McDermott, managing director at Chelsea Financial Services. ‘If they were returning 20 or 30 per cent a year, I’d be asking why, because they’re not supposed to be taking that level of risk.’ 

But many other funds are using long/short equity strategies to take more exposed positions, often involving a lot more long than short. If it works, the rewards are high. Cazenove’s Absolute UK Dynamic, for instance, currently has a 40 per cent net long position, so it’s clearly far from market neutral. But it has returned 30 per cent this year. ‘It focuses on UK small- and mid-cap shares, so there is potential to do really well if you get the long and the short calls right,’ says McDermott. 

However, there’s a high risk of extreme short-term swings in performance if the manager gets both calls wrong. McDermott gives the example of L&G’s Diversified Absolute Return fund: ‘It has returned 18 per cent over the year, but is down 6 per cent over the past three months.’ 

Unfortunately, a number of managers have failed to deliver on these more aggressive mandates. Philip Pearson, partner at Southampton-based P&P Invest, picks out SVM UK Absolute Alpha, down 4 per cent over the year. ‘It has failed to meet its objectives in any one year since launch in March 2009 and it’s down 10 per cent over that period,’ he says. 

The sector also contains funds  – Newton Real Return, for instance – that avoid shorting altogether and rely exclusively on asset allocation. 

The diverse nature of the sector, and its disparate returns, have attracted calls for a split from bemused advisers and providers. It is about to be reviewed by the IMA ‘to see whether the sector definition is still fit for purpose,’ says an IMA spokesperson. 

If subdivision is deemed a good idea, the question then is on what lines. Some commentators are calling for splits according to asset class or investment vehicle. LV=, for instance, suggested separating out funds that use structured products or short stocks, as they pose different risks for investors. 

James Davies, portfolio manager at Close Asset Management, believes separating by asset class offers the best chance of clarity. ‘The sector needs to be split to enable investors to more clearly understand the delineation between funds,’ he says. 

However, McDermott argues that asset class is irrelevant, and that what’s important in this sector is what the fund is achieving and at what risk. He believes the split should be on target and volatility lines. Those aiming for returns of cash-plus with minimal volatility over a year would be separated out from their racier peers. 

He says: ‘When we look at an absolute return fund, we ask how many months of negative return it’s had over the past year. We’d expect the odd bad month because any manager can make a bad call – but if there have been a lot, that’s a risky fund. However, some of the more aggressive, volatile funds allow themselves longer to produce their positive returns.’ Such funds could be categorised as ‘absolute return higher volatility’, he suggests.

Fund focus: actual returns are often underwhelming

BlackRock UK Absolute Alpha 

Mark Lyttleton and Nick Osborne’s fund is one of the longest-running in the sector. It is run as a market-neutral fund, holding a mix of UK equities with derivatives and options to hedge against volatility. It aims to deliver a positive return by beating cash every year. But although performance in the early years was impressive, in the past couple of years it has been disappointing. According to Lipper data, over the 12 months to 30 June, the fund returned 2.7 per cent, and over three years it managed less than 2 per cent. 

However, Darius McDermott points out that, although it has done ‘bugger all’ recently, over five years, things look much better, with the annual return averaging almost 6 per cent. ‘I believe Mark Lyttleton is a good manager and we haven’t taken the fund off our buy list so far,’ he says. 

Lyttleton acknowledges recent poor stock selection, but says he ‘remains excited about the outlook for many of the fund’s holdings’.  Total expense ratio (TER): 1.91 per cent

CF Odey UK Absolute Return 

This sector-topping fund, managed by James Hanbury, is too young to have a three-year track record, but a quick glance at its performance since launch in May 2009 highlights the fact that it’s a relatively racy beast. It has returned more than 60 per cent since launch and 38 per cent in the year to the end of June alone. 

It holds around 60 per cent in UK equities, with the balance in fixed interest and cash, but may take quite significant long/short positions. As Philip Pearson observes: ‘Although the performance has been good, this has come at the cost of extreme volatility.’ 

‘Many people dumped the BlackRock fund for this one because it’s done so well, but it’s really not directly comparable,’ adds Mark Dampier. He also flags up the hefty performance fees: ‘There’s no hurdle rate for them to achieve before performance fees kick in, so they’re taking 20 per cent of all they make.’ TER: 1.37 per cent

Newton Real Return 

This broad-based multi-asset fund relies exclusively on asset allocation and simple derivative strategies to achieve positive returns and reduce volatility; it does not sell stocks short. Investment decisions are made following Newton’s characteristic top-down global thematic approach, with the aim of beating Libor by 4 per cent. 

‘If they think a type of fixed interest looks favourable, even if fixed interest as a whole is not doing well, they’ll go there,’ explains James Davies. 

The fund has performed consistently, returning an average of 10 to 11 per cent a year over three and five years. Davies likes the fact that, unlike many funds in the absolute return sector, there is no performance fee. TER: 1.12 per cent