Absolute return fees soar
As the absolute return sector swells in size, concern is growing over the high fees levied by the funds.
In the past few months, Legal & General, Gartmore and AEGON have unveiled funds in this space, and a long list of fund management groups, including Aviva Investors, Old Mutual Asset Managers and Deutsche Bank, are planning to launch absolute return products later this year.
There has been explosive growth in the number of absolute return funds available to private investors: three years ago there were just six, now there are 27.
The concept seems attractive: to always deliver a positive return, so that even when markets look volatile, your investments won't take a tumble. This is often achieved by shorting stocks. The catch is that in a bull market a fund will likely underperform the relevant index.
However, some funds are failing to consistently deliver a positive return and many charge hefty performance fees. In February, the average return for an absolute return fund was 0.1%, while the top fund delivered 2.8%. This means some posted negative returns.
The biggest irritation for many IFAs though is the performance fee. Legal & General's two new funds and AEGON's UK Equity Absolute Return fund have a 20% performance fee on top of initial and annual charges.
Jupiter's popular Absolute Return fund, which launched in December, has a 15% performance fee. The hurdle for these fees is typically the Bank of England base rate or LIBOR.
"The performance fee is a nice income generator for fund management firms," says Patrick Connolly, head of communications at AWD Group.
He adds: "Investors will ask why they are paying the high price if the market shoots up and the fund lags the market. There should be a fee reduction for underperformance."
Martin Bamford, managing director of IFA firm Informed Choice, agrees. "With interest rates so low, this is not a particularly high hurdle for fund managers to cross before they get paid even more of the returns from the fund.
"As with all performance fees, there is no return of fees to the client when the fund performs badly," he says.
It's not just advisers who find the fees hard to stomach. Schroders, which does not run any absolute return funds, agrees that some of its competitors charge "extortionate fees".
Robin Stoakley, head of UK retail, says: "If a fund has a target of 6 to 12% return a year, and it delivers 12%, the total expense ratio could hit 3%. This means a quarter of the return is taken up by fees."
He says part of the reason fees are high is because managers are used to running hedge funds "with very fat fees". Stoakley hopes fees will come down.
Richard Pursglove, head of UK retail at Gartmore, admits that fees are higher than long-only equity funds, but says one of the reasons is because only a few mangers can run such mandates.
According to Pursglove, absolute return funds are "on the same journey that corporate bond funds have been on over the past 10 years". He believes the absolute return space will expand just as the corporate bond fund sector has.
Time will tell how the sector evolves. Research by AXA shows that more than 50% of IFAs expect their clients to invest in absolute return funds this year. However, Bamford has seen little interest from investors and says last year only one client asked about absolute return.
This article was originally published in Money Observer - Moneywise's sister publication - in April 2010
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.
Total expense ratio
Most investment funds levy an initial charge for buying the units/shares and an annual management fee but other expenses also occur in running the fund (trading fees, legal fees, auditor fees, stamp duty and other operational expenses) which are passed on to the investor and so the TER gives a more accurate measure of the total costs of investing. The TER is especially relevant for funds of funds that have several layers of charges. Unfortunately, investment fund companies are not obliged to reveal TERs and many only publish the initial charges and annual management charge (AMC).
A financial adviser who is not tied to any financial services company (such as a bank or insurance company) and is authorised by the Financial Services Authority (FSA). They can advise on financial products to suit your circumstances. All IFAs have to give consumers the choice of paying by fees or commission and have to explain which would best suit the customer in that particular instance. Also, if commission is paid either by the client or the financial service provider recommended by the IFA, the IFA must disclose what that commission is.
A sophisticated absolute return fund that seeks to make money for its investors regardless of how global markets are performing. To that end, they invest in shares, bonds, currencies and commodities using a raft of investment techniques such as gearing, short selling, derivatives, futures, options and interest rate swaps. Most are based “offshore” and are not regulated by the financial authorities. Although ordinary investors can gain exposure to hedge funds through certain types of investment funds, direct investment is for the wealthy as most funds require potential investors to have liquid assets greater than £150,000m.
Also referred to as the bank rate or the minimum lending rate, the Bank of England base rate is the lowest rate the Bank uses to discount bills of exchange. This affects consumers as it is used by mainstream lenders and banks as the basis for calculating interest rates on mortgages, loans and savings.
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.
Corporate bonds are one of the main ways companies can raise money (the other is by issuing shares) by borrowing from the markets at a fixed rate of interest (the reason why they are also known as “fixed-interest securities”), which is called the “coupon”, paid twice yearly. But the nominal value of the bond – usually £100 – can fluctuate depending on the fortunes of the company and also the economy. However it will repay the original amount on maturity.
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.