A fund that will deliver a positive return whatever happens to the markets sounds too good to be true. James Phillipps puts absolute return funds to the test

Absolute return funds have been one of the most hyped products this year and appear to offer the holy grail of steady, positive returns regardless of market conditions.

The majority of investors may have run for the hills but plenty have been lured in by the opportunity of making money even when share prices are falling.

Over £700 million of retail cash was poured into absolute return funds between June and September alone and several investment houses have been quick to bring products out in response to the demand.

A new concept
Absolute return funds first emerged three years ago as changes ushered in by the UCITS III regulations allowed managers to use derivatives in their portfolios. Their launch was something of a damp squib, however, as investors chased the massive gains being made in more exciting areas, such as commodities and emerging markets.

Now, with the markets in freefall, these ‘quasi-hedge funds’, with their potential to deliver consistent growth while providing downside protection are firmly in the limelight. The objectives of these funds may be the same but there is already a dizzying array on offer using a variety of often highly sophisticated investment strategies to try and meet their aims.

For example, the recently launched Standard Life Global Absolute Return Strategies fund (GARS) arguably receives the twin accolade of being both the most complicated and the most diversified of this new breed of funds. It takes a multi-strategy approach, targeting returns from 24 different strategies as disparate as traditional long-only equities, currency and interest rate plays.

Tam McVie, an investment director at Standard Life Investments, says the aim is to combine a broad range of uncorrelated trades that will enable it to meet its objective of returning Libor plus five per cent over a rolling three-year period. To achieve this, it blends longer-term positions with shorter-term opportunistic plays to take advantage of pricing anomalies.

Taking a view
It benefited significantly from a bet on interest rates falling earlier this year, for example. McVie says, ‘Toward the end of the second quarter, two-year interest rate swaps, which give an indication of where the market expects interest rates to be, were priced at 6.45 per cent and people thought they could even go up. We thought they would have to be cut drastically, and they are now below four per cent; and we believe they still have further to go.’

The fund also made significant gains by betting on the US dollar rising against sterling in the first half of the year. Although this hurt performance initially as the dollar rose to US$2.12 against the pound, it has since fallen sharply. Over the summer, he switched to funding this trade out of euros, which had been holding up well against the greenback. During the third quarter, the euro fell more rapidly against the dollar than sterling, backing his call.

‘We don’t try and time markets but we do look to be opportunistic and we got this one right,’ he says.

Like many other absolute return funds, GARS has also profited from falls in the equity markets but has taken a different approach to many of its peers.

It used derivatives to bet on the FTSE 100 outperforming the FTSE 250 in the belief that mid-caps would be worst affected during the credit crunch. The return the fund receives is the difference in performance between the two indices, and this trade, known as a relative value trade, has made 11 per cent this year.

A range of approaches
The BlackRock UK Absolute Alpha and Cazenove UK Absolute Target funds both run more traditional long/short equity strategies. Under UCITS III regulations they are not allowed to borrow stocks to short sell them like hedge funds, but instead use contracts for difference (CFDs – a kind of derivative) to obtain this exposure.

The BlackRock fund, managed by Mark Lyttleton, has been the shining star of the sector, making positive monthly gains from August 2007 until July 2008 despite the market turmoil. In the past eight months alone, the fund’s size has ballooned from £420 million to £1.5 billion as investors have piled in.

Lyttleton essentially runs the portfolio as a hedge fund combining long and short equity bets and, at times, heavy cash weightings. He says he has also made a lot of money out of pairs trading, which is a market-neutral bet on the fortunes of different companies in the sector. This involves going long on a stock he likes, using GlaxoSmithKline as a hypothetical example, and shorting a rival such as AstraZeneca in the belief that the market will recognise the former’s greater potential. At the same time, this protects the fund from any external shock that affects the whole sector.

Cazenove UK Absolute Target takes a similar approach and is run by Tim Russell, an experienced hedge fund manager. He points out that the fund made a 2.7 per cent gain in October compared with a 10.7 per cent fall in the FTSE 100, with gains from the short positions outweighing the losses from his long holdings.

Russell reports that ‘It was a volatile month for us, as it was for the market, with the fund in the first two weeks of October falling by four per cent, before rallying strongly in the second half of October.’

He adds, ‘Our long book detracted 8.2 per cent from current asset value while our short book added 10.6 per cent.’ Russell is renowned for his approach to filtering his stock selection through his analysis of where we are in the economic cycle.

A macro view
The Threadneedle Absolute Return Bond fund, however, takes an almost entirely top-down view of the world. It invests across a blend of government debt, corporate bonds and currency and has the ability to use derivatives to short or hedge positions. Manager Quentin Fitzsimmons says the fund has gained from being heavily weighted in government bonds, one of the few asset classes to prosper during the credit crunch, and being massively underweight bank bonds, which have lagged severely.

He says, ‘Performance has also benefited from the tactical short-term trading of
US treasuries, mainly through options and particularly towards the lower-yield end of the curve, both in ten-year and long bonds.’

The Threadneedle Absolute Return Bond fund has also prospered from its exposure
to the yen and Swedish krona and is the top-performing absolute return fund over
the year.

A difficult start
Comparing performance between absolute return funds can be tricky, however. For example, The Investment Management Association (IMA) only launched its
absolute return sector on 28 April, and fund management houses can choose whether their funds that are run on an absolute return basis appear there or in more general sectors that reflect their broader investment focus.

In addition, many of these funds also have very short track records, and these are as diverse as the underlying strategies that the managers use when running them.

However, with even the absolute return sector down 5.49 per cent on average since its inception, the products certainly have their critics.

Rex Cowley, marketing director at Close Investments, believes they have not lived up to expectations, saying: ‘It is disappointing that so many absolute return funds have failed to deliver for investors at a time when they need returns the most.’

But others believe this does not tell the whole story, with Tony Lanning, head of multi-manager at Gartmore, noting that the FTSE 100 fell by 26.83 per cent over the same period. He points out that the market conditions are exceptional, with the third quarter one of the worst in history. All asset classes barring cash and the highest-quality government bonds crashed in value as confidence collapsed.

‘Whether they have achieved what people expected of them really depends on what their expectations were, but my view is that to expect any equity-based investment to perform in these market conditions is unfair on the manager,’ Lanning says. ‘While it is disappointing to see their numbers in negative territory, you have to put it in perspective and compare them with traditional long-only funds.’

Diversification benefits
Mark Dampier, head of research at Hargreaves Lansdown, agrees, saying that he believes investors will be well served by holding absolute return funds as a portfolio diversifier.

Lanning backs the BlackRock UK Absolute Alpha fund and says it is a core holding in both the Gartmore Cautious Managed and Balanced Managed funds he oversees: ‘Mark Lyttleton has been criticised after the fund fell seven per cent in the third quarter, but over the year it is down 0.1 per cent compared with the market’s 40 per cent fall.’

Dampier also backs Lyttleton but suggests blending it with the Standard Life, Cazenove and Threadneedle funds because they all perform differently. ‘Holding three or four different funds is sensible as a diversifier, just as you would hold three or four different UK growth funds,’ he says.