Are absolute return fund managers up to the job?

Ask virtually any investor and they will say that their main aim is to maintain their capital. Traditionally, however, most fund managers have been far more concerned about keeping close to their chosen benchmark than staying in positive territory.

As a result, the average UK all companies fund has lost almost 12% over the past three years, while the average annual sector return over the past decade has been a little over 2% - less than you would have earned in a building society.

Rather belatedly, investment managers are waking up to the importance of capital preservation. The clearest indication of this is the rush to launch absolute return funds. A decade ago the Newton Real Return fund had the sector to itself. Now it has 30 competitors, and that number is set to rise sharply.

New launches

Among the more interesting of the planned new launches are two new funds, Jupiter Absolute Return and Jupiter International Financials, run by Philip Gibbs, who has made the most of his limited hedging options to make his Jupiter Financial Opportunities fund one of the best performing on the market, with an average return of 20% a year since its launch 12 years ago.

BlackRock UK Absolute Alpha, run by Mark Lyttleton and a favourite among most intermediaries, has been one of the best-selling funds over the past year and has grown to more than £1.5 billion since it was launched in 2005.

The attractions of absolute return funds are clear: none of the seven funds with a three-year track record lost money over the period and the average gain was more than 16%. But before you rush into this sector, you should know how to differentiate between the funds and understand the risks.

If running a traditional fund is hard, managing one that can short stocks or indices - sell assets you don't own in the hope that their price will fall - and use arbitrage, hedging and other absolute return strategies is much harder. That is particularly true if the fund can invest across a range of asset types.

Hugh Adlington, investment director at Rathbone Investment Management, points out that shorting a stock when the price rises increases the fund manager's exposure - and, in theory, the losses can be infinite. For this reason the firm prefers to back established hedge fund managers with a track record in running such funds.

Handle with care

But he cautions that even experienced hedge fund managers may not be able to transfer their skills to the retail market. "The Ucits III rules [which allow some hedging techniques to be used] mean that it can sometimes be difficult to replicate the strategies from existing [institutional] funds," says Adlington.

He adds that investors must also be prepared for substantially higher fees, as the manager will generally take as much as 20% of any gains above the performance target on top of annual charges of 1.5% or more.

Investors should ensure that the performance target is sufficiently robust - targets are usually a fixed percentage above the Libor bank lending rate - and that if managers underperform, the shortfall is clawed back before they can start to earn performance fees again.

They should also be aware that the price of not losing in a market slump can be gaining much less in a bull market.

Investors should also consider the strategies and types of investment the fund can use. Brian Dennehy, principal of financial advisers Dennehy Weller & Co, says that few of the funds have long enough track records to allow potential investors to judge whether the managers can make money across a cycle.

His analysis of four that have - from BlackRock, Newton, Threadneedle and Baring - found that BlackRock's is the most consistent performer.

This article was originally published in Money Observer - Moneywise's sister publication - in December 2009