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.
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
The London Inter-Bank Offer Rate is the rate at which banks lend to each other over the short term from overnight to five years. The LIBOR market enables banks to cover temporary shortages of capital by borrowing from banks with surpluses and vice versa and reduces the need for each bank to hold large quantities of liquid assets (cash), enabling it to release funds for more profitable lending. LIBOR rates are used to determine interest rates on many types of loan and credit products such as credit cards, adjustable rate mortgages and business loans.
Usually charged as a percentage of returns for performance above a specified benchmark, such as an index. The fee can range from 10% to 20% of total investment returns on a low starting benchmark such as Libor and investors could find themselves paying extra fees for merely average performance. Note that these funds do not compensate investors when the manager underperforms the benchmark.
An individual employed by an institution to manage an investment fund (unit trust, investment trust, pension fund or hedge fund) to meet pre-determined objectives (usually to generate capital growth or maximise income) in prescribed geographic areas or investment sectors (such as UK smaller companies, technology or commodities). The manager also carries the responsibility for general fund supervision, as well as monitoring the daily trading activity and also developing investment strategies to manage the risk profile of the fund.
A bull market describes a market where the prevailing trend is upward moving or “bullish”. This is a prolonged period in which investment prices rise faster than their historical average. Bull markets are characterised by optimism, investor confidence and expectations that strong results will continue. Bull markets can happen as a result of an economic recovery, an economic boom, or investor irrationality. It is the opposite of a bear market.
A standard by which something is measured, usually the performance of investment funds against a specified index, such as the FTSE All-Share. Active fund managers look to outperform their benchmark index. Cautious fund managers aim to hold roughly the same proportion of each constituent as the benchmark, while a manager who deviates away from investing in the benchmark index’s constituents has a better chance of outperforming (or underperforming) the index.
This is a mutual organisation owned by its members and not by shareholders. These societies offer a range of financial services but have historically concentrated on taking deposits from savers and lending the money to borrowers as mortgages, hence the name. In the mid-1990s many societies “demutualised” and became banks. One academic study (Heffernan, 2003) found demutualised societies’ pricing on deposits and mortgages was more favourable to shareholders than to customers, with the remaining mutual building societies offering consistently better rates. In 1900, there were 2,286 building societies in the UK; in 2011, there are just 51.
Absolute return funds
Absolute return funds aim to deliver a positive (or ‘absolute’) return every year regardless of what happens in the stockmarket. Unlike traditional funds, they can take bets on shares falling, as well as rising. This is not to say they can’t fall in value; they do. However, over the years, they should have less volatile performance than traditional funds.