The value of investments can fall as well as rise and you could get back less than you invest. If youre not sure about investing, seek independent advice.

In a climate of economic uncertainty, many investors are opting for targeted absolute return funds to limit any potential losses, but how do these work?

What the benefits and drawbacks are of this sector.

Why these funds may be a useful part of a diversified investment portfolio.

Targeted absolute return funds are proving a popular choice among investors who are seeking to reduce volatility during periods of economic uncertainty.

These funds were the best-selling sector in the first six months of this year, according to the Investment Association, with net inflows of 2.2 billion.1Absolute return funds aim to deliver positive returns in all conditions, and with less volatility than the wider market, making it easy to understand their appeal as a way to weather any potential stock market storms.

However, the performance across the absolute return funds sector has recently been poor.2If you are considering this or any other type of investment, its important to remember that you could still lose money, as these and all investments can fall as well as rise in value. If you are unsure what to invest in, you should seek professional financial advice.

Absolute return funds can invest in a wide range of assets, but in contrast to traditional fund sectors they may use more complex investment financial instruments derivatives and currency hedging – to achieve their aims. Despite these funds having a similar overall objective, the particular investment strategy adopted by a particular fund will depend on the approach of the manager.

Some of these funds, for example, invest in a single asset type, such as bonds or equities, while others include a broader range, including property, commodities, and currencies. They may also invest in assets across different geographical regions across the world, or focus on a particular market, such as the UK or emerging markets.

These funds also use derivatives, or financial instruments more typically associated with hedge funds, that track the performance of an asset, rather than holding the asset directly. A derivative is traded between two parties, known as counterparties. If the issuer of the derivatives doesnt pay the sums due, or goes bust, you could lose some or all of your capital. Derivatives are both complex and risky so its important for investors considering absolute returns funds to understand what they are buying, and to seek professional advice if unsure. Derivatives and other more sophisticated investment strategies, including currency hedging, are aimed at reducing volatility and preserving capital. Currency hedging, for example, aims at reducing or eliminating the impact of exchange rate movements on returns from overseas shares by using currency exchange contracts. If all of the foreign currency exposure of a fund is hedged against, the return should only come from the movement of the stocks held. Again, currency hedging involves a high level of risk, as if currencies dont perform as the manager expects, the fund could lose money.

As absolute return funds often hold alternative assets such as currencies and commodities that have less correlation to the performance of shares and bonds. The currencies and commodities, for example, may potentially perform differently during periods of market volatility, perhaps offsetting losses from other investments though of course their losses may also offset other gains.

However, the targeted absolute return sector was recently subject to scrutiny by the Financial Conduct Authority (FCA) in its asset management market study. The regulator commented on potentially misleading performance reporting, and said of this sector: We also agree that the wide range of charges and targets could be confusing to retail investors, and is unlikely to help investors compare performance even within the absolute return sub-sector.3

The sector has faced criticism because some funds have failed to perform as hoped, taking such a cautious investment strategy that they have struggled to produce greater returns than cash over the past year, proving that their strategy to protect capital doesnt always work in investors favour. Other absolute return funds are considered to take greater risks with their investment strategy than might have been expected from this sector.4

It can certainly be tricky to truly compare absolute return funds, as there is such a wide variety aimed at different attitudes to risk from the cautious investor to the adventurous, and using different investment styles.

The Investment Association included the word Targeted to the absolute return sector to ensure that investors are aware that while positive returns are the aim for fund managers, they are not guaranteed.5As with any other investment you might choose, your might get back less than you originally invested.

Before investing, make sure to consider ongoing charges, which may be greater than for other fund sectors. You should bear in mind that charges can have a significant impact on your returns over the long-term, so its important to check exactly how much you are paying.

In addition, absolute return funds may levy a performance fee, paid to managers when the fund exceeds the particular benchmark a fund pits itself against. The FCA has said that some funds have too low a performance threshold, while others are based on gross rather than net performance.6Typically, performance fees are not levied on traditional funds in other sectors.

For investors willing to do their research and accept the risks involved, targeted absolute return funds may be a useful part of a diversified investment portfolio.

However, which absolute return fund is right for a particular investor will depend partly on their attitude to risk, with some suitable for cautious investors, and others taking a more adventurous approach for those who are willing to potentially cope with greater losses.

Given the widely different investment styles taken by fund managers within the targeted absolute return funds sector, its particularly important to read the fund documents carefully and do the relevant research before investing. The particular strategy taken will have an impact on the level of risk involved in investing in a particular fund.

Fund options within the absolute return sector include the Aviva Investors Multi Strategy Total Return fund, Newton Real Return fund, and the Standard Life Investments Global Absolute Return Strategies fund. Please remember that our referring to these does not constitute advice or a personal recommendation to invest in these funds, or any other investment.

Investments can fall as well as rise and you may get back less than you invested. Past performance isnt a reliable indicator of future performance.

Remember, the value of investments can fall as well as rise and you could get back less than you invest. Seek independent advice if youre unsure of this investments suitability for you.

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2Investors abandoned shares and property funds in 2016 in favour of lacklustre absolute return funds (February, 2017)

3Financial Conduct Authority, Asset Management Market Study, June 2017 [PDF, 1.3MB]

4Interactive Investor, Are absolute return funds a better way to invest in an uncertain world? (August, 2017)

5Investment Association (February, 2013) [PDF, 209KB]

6Citywire, FCA stands by all-in fee and takes aim at performance fee (June, 2017)

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