Share prices staged a recovery this week, amid optimism over the prospects for America, the world’s biggest economy. However, investors realise that the concerns that caused the global stock market rout have not disappeared. The anxieties surrounding Brexit are adding to the worries about the oil price and global growth.
This should be the moment when absolute return funds, which are supposed to deliver a positive return ahead of cash in all market conditions, should be looking particularly attractive compared to traditional funds that aim only to beat abstract market benchmarks and sustain losses when those markets fall. However, there are question marks over some absolute return funds’ failure to deliver in past market downturns. Before you invest this year’s £15,240 Individual Savings Account (Isa) allowance in one of these funds, this is what you need to know.
What do these funds do?
Their goal is to deliver positive returns across different market environments. In comparison, traditional funds aim to outperform a specific target, such as the FTSE All Share Index. In reality, most absolute return funds don’t deliver a return in all market conditions, so the official sector name was changed to targeted absolute return funds.
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How do they work?
The underlying strategies involved are more complicated than simply buying shares or bonds that the manager thinks will rise, and the funds will typically use more sophisticated instruments, such as contracts for difference, and other forms of derivatives too.
Jason Hollands, of Tilney Bestinvest, the adviser, says: “Absolute return is also a catch-all banner for a range of approaches, which include multi-strategy funds; long-short funds, where the managers are able to bet on the losers as well as the winners and global macro funds, which take positions in different asset classes and markets.”
Who are they suitable for?
Mr Hollands says: “They can help fill a gap that used to be provided by bond funds. Historically, bonds have been a key defensive, less volatile asset class to help reduce risk in a portfolio. However, years of ultra-low interest rates and big stimulus programmes, involving central banks buying bonds, has distorted bond prices and resulted in low yields. This made investors wary of them, because they believe that when interest rates rise they will endure losses.
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“Against this backdrop, as well as a more uncertain environment for global stock markets, the funds have grown in popularity as an alternative source of stability for investment portfolios.”
Which is the best?
A multi-strategy fund should be the first port of call because these will provide a one-stop shop approach to absolute return investing. These funds — like Invesco Perpetual Global Targeted Returns and Standard Life Global Absolute Return Strategies — effectively provide an umbrella for a wide range of individual investment strategies.
They can involve taking views on which countries will raise interest rates, making money out of differences in exchange rates, selling shares in one market to buy shares in another and many other investment views.
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Damien Fahy, of 80-20 Investor, the DIY investment service, recommends the Kames UK Equity Absolute Return fund. He says: “It’s one of the few absolute return funds that is not correlated to UK shares. In fact, in the past six market corrections, this fund has produced a positive return in five.
“It aims to achieve a positive return in all market conditions, which has historically equated to about 3.6 per cent per annum since 2010. Also, the fund doesn’t charge a performance fee.”
The fund’s top holdings include shares in Pets at Home Group, the pet product and grooming company; Go-Ahead Group, the train and bus operator; and BT Group, the telecoms giant.
Mr Fahy adds: “For those looking for more upside potential then the Jupiter Absolute Return fund aims to produce positive returns over a three-year period. And like the Kames it does not apply performance fees. The fund is more volatile than the Kames fund but doesn’t track the wider market. It’s up almost 6 per cent a year to date.”
How can I compare funds?
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The Investment Association has a helpful targeted absolute return fund filtering tool that summarises the various strategies, objectives and risk levels at theinvestmentassociation.org. You can also find fund data, including performance data, on websites such as Morningstar and Yahoo Finance.
What are the downsides?
Traditional funds will see significantly bigger gains than absolute return funds in rising markets and over the long term. Mr Fahy says: “To be honest 3 per cent a year return is not a hell of a lot better than cash. Over the last year even the likes of Kames have only just made a profit.
Other types of fund make much bigger returns in the long term. Over the past five years the average UK equity fund is up 37 per cent, despite the market correction. The average absolute return fund is up just 12 per cent.”
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How do charges stack up?
Mr Fahy says: “The funds are often expensive, with a typical annual charge of 1.8 per cent. In fact, absolute return funds have the highest average charge, second only to funds of funds. Also some funds apply performance fees despite mediocre returns, which makes their charging even more opaque.”
The best of the bunch
● Look for consistency of returns, so look at how the fund performed when the wider market fell. Seek those funds with a low correlation to the wider market. A lot of absolute return funds are still highly correlated to the stock market.
● See returns in context. Of course, while you want downside protection you also want some upside for the risk you are taking by investing in the markets. Otherwise you might as well simply sit on cash.
● Check their targets. Absolute return funds have their own objectives, such as a positive return over 12 months. Always review a fund’s objectives so you have realistic expectations. The longer the timeframe a fund has to achieve its targets, the greater the risk it is likely to take.
● Be realistic. If you are looking to targeted absolute return funds for downside protection then you will be giving up more of the potential upside. Don’t be surprised if you earn little more than “cash plus 2 or 3 per cent” a year.