If you hate losing money when stock markets are falling, you're not alone. Investors need nerves of steel to cope with the recent stock market mayhem. But there may be a way to avoid today's stock market hyper-volatility while securing a far better return than you can get on cash. Absolute return funds claim to offer investors the holy grail of fund management by targeting positive returns of between 7 per cent and 10 per cent a year regardless of whether markets are rising or falling.
That's a great selling point, especially now, but is absolute return really as fabulous as fund managers claim? Absolute return funds have come of age during the past three years, with growing demand and regular new fund launches. You can now choose from a range of offshore funds from managers such as Aviva, GAM, Henderson, HSBC, Insight, Julian Baer, Jupiter, Old Mutual, Polar Capital and UBS. There are also about 40 absolute return funds registered in the UK, from managers including BlackRock, Jupiter, Legal & General, Newton, Threadneedle and others.
Absolute return is the latest attempt by the fund management industry to seduce private investors by combining the potentially higher returns available on equities with the greater security of cash. It has proved a difficult trick to pull off in the past. Absolute return managers have much greater freedom to choose how they trade the stock market, including the ability to use complex derivatives to "short" markets, shares or currencies, and cash in when they fall. They have certainly had plenty of opportunities to do that lately.
This gives the manager more flexibility than traditional "long-only" funds, which only invest in stocks the manager expects to go up, and therefore rise in value when markets rise, and fall when they fall. The best absolute return managers claim to "generate alpha" by using their freedom to make big calls either for or against the market. If they do their job properly, they should produce positive returns in years when share prices are falling, and a similar return when they are rising.
The drawback is that they will trail the market during a bull run, but at least you avoid all that stressful volatility in between. Past sector performance suggests many funds have fulfilled their remit. The average offshore absolute return fund is up 18 per cent over the past three turbulent years, according to figures from Trustnet.com, while the average offshore US equity fund is down 19 per cent.
Over the past 12 months, which included last year's dramatic market rally, the average absolute return fund grew 12 per cent, but US equities soared 30 per cent. So you avoid the pain during the bad times, but miss out on the euphoria in the good. Instead, you get a flat, even return. Some investors will like that. Some won't. Absolute return funds can smooth out the swings in your portfolio because they have relatively low correlation to the stock market, says Hugh Cutler, head of distribution at Legal & General, which has just launched two new UK-registered absolute return funds, UK Absolute Fund and European Absolute Fund.
"If you only invest in traditional, long-only funds, your wealth will follow the market. If share prices rise, the value of your funds rise. If shares fall, so do your funds. Absolute return funds give you diversification because they behave in a different way to stock markets." Mr Cutler says the freedom to short stocks makes them similar to hedge funds. But while hedge funds are the preserve of wealthy investors, absolute return funds are open to everybody.
"Some people think absolute return funds sound risky, but that isn't necessarily the case," he says. "With a skillful manager and reasonable risk management, you shouldn't lose your shirt. Whereas if you had invested in conventional equity funds over the past decade, you would have lost it twice." But it all depends on the quality of your fund manager. "Absolute return managers have absolute freedom to decide which stocks to invest in, and whether to go short or long. This is a powerful tool, but in the wrong hands it can cause a lot of damage," Mr Cutler says.
Absolute return funds appear to offer the best of both worlds, says Dan Dowding, the chief executive (Middle East & Asia) at independent financial advisers Killik & Co in Dubai. "They offer a steady return above cash when stock markets are rising, and downside protection when they fall," he says. "For some investors, this is a no-brainer, but others are sceptical." Some funds have underperformed, a reminder that you aren't getting a risk-free return. "There is no hard guarantee that your fund will rise year after year, some may fall, it depends on the manager. Some funds also target higher returns, and may take more risks to achieve them."
The sector is typically popular in bear markets, but slides out of favour when investors feel bullish. "While a target return of 7 per cent to 10 per cent a year is perfectly respectable, it is less attractive when the market is returning 20 per cent or more, as it did in 2009," Mr Dowding says. Another drawback is that they have higher charges than traditional investment funds, which partly explains why fund managers are so keen to launch them.
"Most funds charge high annual management fees of between 1.5 per cent and 1.75 per cent a year, with a performance fee on top, which might be 20 per cent of your return above a certain level. They also have initial charges of up to 5.25 per cent, although a reputable broker or adviser should discount these, ideally to zero. You have to decide whether these fees are justified." Provided you understand the risks and the costs, Mr Dowding says absolute return funds do have a place in your portfolio.
"They can work well both for cautious and aggressive investors. If you're worried about stock market volatility, they can give you steady growth. If you're feeling positive, you can still use them as a core holding to balance your more aggressive investments." James Thomas, regional director of Acuma Wealth Management in Dubai, warns that the theory is often better than the experience. "Performance isn't always as consistent as you would expect," he says. "Schroders ISF Emerging Markets Debt Absolute Return, for example, rose 17 per cent last year but actually fell 2.2 per cent in 2008, and performance this year has been flat so far."
Another worry is that they use exotic investment techniques such as short selling, futures, options, derivatives, arbitrageur and leverage. "These are technical terms and quite confusing to the average investor, which means they don't always know what they are getting into," Mr Thomas says. Spencer Lodge, regional director at financial brokerage PIC, a wholly owned member of IFAs deVere Group, says absolute return funds have been very much in vogue over the past year. "If you asked most investors whether they would like a fund that is geared to providing 7 per cent to 10 per cent growth a year, they would be delighted to accept," he says. "That looks even more attractive when you consider that a fund tracking the FTSE 100 would have actually lost money over the past decade. But if you offered this to speculators who wanted bigger returns, it might not appear so attractive." Mr Lodge stresses that returns are far from guaranteed, and are heavily dependent on the skill of your chosen fund manager. So tread carefully. "Anyone in the UAE can approach an independent financial adviser to talk about the benefits of adding an absolute return fund to their portfolio." firstname.lastname@example.org
There are other ways of avoiding stock market volatility without using absolute return funds. For one, even more risk-averse investors can consider principal-protected notes, which are bond-like vehicles that guarantee your original payment, as long as you hold the note to maturity. But having this guarantee comes at a cost - the fees can be quite high, and it can also be very hard to track your investment before you cash in. Many investors prefer to protect themselves by investing in a spread of different assets, such as shares, bonds, cash and property. This is called diversification, and the idea is that if one asset class falls, another may cushion the blow. If you are investing for the long term, you don't have to worry so much about short-term volatility, says Alwyn Owens, an independent financial adviser at Dubai Financial Advice. "Stock market volatility comes with the territory. That's why you should invest for a minimum five years, and preferably 10 years or longer, to give you time to overcome any short-term troubles," says Mr Owens. Recent stock market falls might even be a buying opportunity because you will be able to pick up good shares and companies at cheaper prices. "I believe emerging markets such as India, China, Russia and Latin America will provide the best investment returns in the longer run, as the balance of wealth and power shifts away from the West. They may be volatile, but in the long run you should come out on top." No matter how painful you find the current volatility, now isn't the time to sell because that way you will merely crystallise your paper losses. It is better to be patient and hope that markets will eventually recover. * Harvey Jones