An absolute guaranteed success?

Absolute return funds sound like the perfect investment. Regardless of what's happening in the global stockmarkets, these products aim to deliver positive returns every year.

And they certainly appear to have achieved this goal during the past 12 months: the average fund in the IMA Absolute Return - UK sector is up almost 11%, according to statistics compiled by Morningstar (to 3 May 2010).

Of course, that's not much to boast about - most sectors were in positive territory during 2009 as stockmarkets bounced back, and some delivered substantially more. The IMA Global Emerging Markets sector, for example, rose by more than 50%.

The real benefits of this sector, however, were illustrated in the year to 1 May 2009, at the height of the financial crisis. While the vast majority of managers lost money, the average absolute return fund went up by 3.42%.

For anyone nervous about risking their hard-earned cash in equity markets after the recent crash, this will sound very encouraging: tuck some money away now and rest easy knowing you will have made a profit by next summer.

The complicated reality

If only it was that simple. The reality is that IMA Absolute Return UK is one of the most complicated sectors you can invest in.

Getting to grips with all the various funds and strategies can be a challenge for even the most experienced financial advisers.

In order to achieve their goals, not only are these portfolios allowed to invest in asset classes as diverse as bonds, cash, currency and equities, they can also take advantage of complicated investment tools and techniques, such as the use of derivatives (which, roughly speaking, allow traders to hedge their bets).

The ways in which they operate will also vary enormously. No two funds are constructed in exactly the same way and all are managed differently depending on the asset classes they invest in and their attitude to risk.

Their names add another layer of confusion. Some total return funds, for example, aim to deliver a positive return over cash, while target return funds will pursue a set performance figure. This means it's virtually impossible to compare like with like.

In fact, the IMA actively discourages you from doing so, pointing out that the differences would render any conclusions meaningless.

"Performance comparisons are inappropriate due to the diverse nature of the objectives of the funds populating this sector, including differing benchmarks, risk characteristics and timeframes for delivering performance."

So investors should realise these innovative products are not a guaranteed route to riches and come with health warnings attached - not least because many were only launched fairly recently.

Where should you start?

Andrew Merricks, head of research at Brighton-based Skerritt Consultants, says the sector can be broadly divided into three main categories: equity long/short; bond long/short; and diversified multi-asset.

"I've used each type and I'm using them all more regularly because of their advantages in volatile markets," he says. "No one of these strategies has so far shown any signs of being better than the others as they are all quite new."

Those pursuing long/short strategies will use derivatives to take what are known as 'short' positions in individual equities and indices, enabling the fund to make positive returns when the market is falling.

Multi-strategy funds, like Standard Life's Global Absolute Return Strategies fund, meanwhile, exploit inefficiencies across international markets and invest in a combination of traditional investments such as equities and bonds, alongside more advanced strategies, such as relative value, duration and inflation.

According to Geoff Penrice, a financial adviser with Honister Partners, it's essential to understand what the various strategies are trying to achieve, how a fund intends generating its returns, and the risks it's willing to take.

"You should also consider the role these funds can play in your overall investment portfolio, how they are likely to behave in different environments, and in what ways they can be mixed and matched with other asset classes," he says.

Also, despite their goal of making money, these funds can still lose substantial amounts over shorter periods, as it's impossible to remain immune to market fluctuations on a daily basis.

The flip side of absolute return funds structured to limit investor losses is that you can expect them to underperform when markets are rallying, says Andy Gadd, head of research at Lighthouse Group.

"Even when markets have been volatile there are still no guarantees of good performance, which makes it essential that you look under the bonnet and find out how particular funds are constructed."

Another point to watch is fees. Some absolute return funds will either levy higher annual management charges or demand performance fees for hitting certain targets.

No one minds paying extra if the returns are high enough, but it's worth establishing what stance your fund of choice will take.

Of course, it's still early days for many of these funds. The sector itself was only launched in May 2008 and initially contained just 17 funds. Today there are just under 50, with many prominent investment houses now represented.

And it does seem to have captured investors' imaginations: it has more than doubled in size over the past year and now has just over £10 billion of assets under management, according to IMA statistics.

Millions of pounds are still being invested in these funds every month. During March, for example, the sector enjoyed inflows of £467 million, a figure only beaten by a handful of other sectors such as Sterling Strategic Bonds and Sterling Corporate Bonds.

What does the future hold?

The sector's longer-term success will depend on fund performances over the next few years. Merricks expects winners and losers to emerge as more light is shed on the investment strategies being pursued.

"If a manager is bad at shorting stocks and then compounds that mistake by holding stocks that go down, it could be disastrous," he says.

"It is not a given that absolute return funds will get it right, so there will be some poor performances."

But Ben Yearsley, investment manager at Hargreaves Lansdown, says the goal of targeting a positive return over 12 months could provide an attractive solution for many investors.

"If these funds can provide consistent returns then they may well be used as a long-term core holding within people's portfolios," he says.

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