The rise of a sector that promises returns in any market

The absolute return sector was only formed in April 2008, but its success has helped it pull in a lot of new money and an increasing number of managers.

Funds in this sector seek to make money regardless of market conditions and put a high priority on capital preservation. The sector held up far better than the FTSE All Share over the last year, and with the economic outlook still highly uncertain, it retains its appeal. Yet there are some caveats.

Firstly, some absolute return funds – those with words such as ‘bond’ in their titles – have much narrower remits than others. This can make it harder for them to dodge difficulties than those able to invest in almost any asset class.

Second, their emphasis on capital preservation means they underperform in strongly rising markets – although their resilience in hard times means they can claim creditable long-term figures. 

And lastly, the techniques employed by some absolute return funds, such as taking out ‘put options’ (going short on shares) which they expect to fall, can be risky and expensive. Nick Osborne, co-manager of BlackRock UK Absolute Alpha fund, says: “Shorts are riskier than longs – longs can only ever go to zero, while a short can rise infinitely.”

Launched in April 2005, BlackRock UK Absolute Alpha has become the largest fund in the sector, despite introducing a steep performance fee, which takes 20% of any gains in excess of the annualised returns on 12 month LIBOR (the London Interbank Offered Rate). 

The BlackRock fund is similar to a long/short hedge fund in that it goes short as well as long on individual shares, invests in a variety of asset classes, and is willing to go at least 60% liquid.
The fund tops the sector over three years. But its much increased size, as well as its high fees and heavy concentration on the UK market, could slow future progress.

Osborne says: “Share prices are moving incredibly fast and market volatility is likely to continue, so we’re grateful for the extra flexibility that a fund of this nature gives us. Absolute return products can be nirvana for investors, delivering positive returns irrespective of market direction – however, it’s even more crucial to look under the bonnet to ensure that the managers have the skills and resources to deliver what they promise.”

Newton Real Return fund, which has performed almost as well over the last three years, has no performance fee, is less than half as big, and invests internationally. Formerly called Newton Absolute Intrepid, it does not go short on individual shares, though it does use derivatives to protect the fund against major market movements.

Unfortunately, it was in the middle of rearranging its protective mechanisms when the market nosedived last October, and it suffered a steep setback. But it bounced back rapidly due to its holdings in gold, US fixed interest and some exceptionally defensive equity holdings. As a result, remarkably, it ended 2008 with a net gain.

The fund adopted its absolute return remit in 2004, and Iain Stewart (Newton’s lead manager for multi-asset and global equity market mandates) has managed it ever since.

As Stewart is worried about the financial outlook, the portfolio is relatively defensively positioned, with 56% in equities – with the emphasis on high-yield shares in large, stable businesses – and 15% each in bonds and cash. The balance of the portfolio is mostly in inflationary hedges, such as gold and agricultural exchange-traded funds, plus gold-related equities.

Newton Real Return aims to exceed LIBOR plus 4% per year – and has done much better than that over its five-year life, as well as substantially outperforming the All Share and the MSCI World index.

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