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Many absolute return funds are giving investors a false sense of security and are no safer than equities, experts warn

Absolute return funds are not as safe as their name suggests. Photograph: Caroline Purser/Getty Images

Adverts talk about how absolute return funds deliver positive returns in all market conditions, and highlight their potential for reducing risk reassuring words for nervous investors. But a leading financial adviser is warning that some are seriously underperforming, that fees are too high and the sector should be renamed to avoid confusion.

AWD Chase de Veres Patrick Connolly says: The name absolute return gives the perception of security and implies that funds can give positive returns in all environments. This is not the case.

These funds mix a number of longs (traditionalinvestmentsin shares) plus shorts (derivatives that allow the fund to make money when a stock falls in value). The idea is that managers use these complex hedging techniques to reduce risk and make money in rising and falling markets an attractive option for equity investors who are used to making a return only from a growth market.

The original terminology was that they would be boring but up, says Simon Moore at IFA firmBestinvest. They are meant to tick along nicely in a gloomy environment, but people expecting stellar returns might be a bit surprised.

Candid MoneysJustin Modray goes further. Investors should be rightly disappointed because they have bought into a concept that isnt working, he says. The market has fallen, so this is precisely the period when investors would have expected an absolute return fund to do well. Maybe some fund managers have bet on markets going up, rather than falling, and have been caught out.

Of the 38 funds around for the last year, just 12 posted a positive return in the first six months of this year (to 2 July), with the remaining 26 losing money, according toTrustnet. The best performer was theStandard Life Global Absolute Return Strategies fund, returning 6.1% in 2010, followed byRuffer Absolute Returnwith 4.3%.

The worst performer is theOctopus Absolute UK Equity fund, which holds more than 125m of investors money. It has lost a whopping 19.7% so far this year yet, says the product literature, it is managed, against a cash benchmark rather than any UK equity index, reflecting the aim to deliver a positive return in all stock market conditions.

A spokesperson for Octopus Investments says: The fund is for sophisticated, long-term investors its not something to get into one month and out of the next … There is no need for our investors to panic.

Connolly says: If we have a period of growth, then the chickens might come home to roost as customers see their absolute return funds have been left behind by equity funds. While the market is moving sideways, the industry can get away with it.

Richard Pursglove, head of UK retail at absolute return fund providerGartmore(whose funds have held up reasonably in 2010), says the sector is a mixed bag at a relatively embryonic stage and that it will evolve. What is crucial is working out how a manager is achieving his performance. Over the next three years we may well see some new sub-sectors springing up that will better define the various types of funds and strategies employed by managers.

This would help investors to gain a better understanding of a funds risk-profile. Connolly says: If they are simply diversified funds, then call them diversified funds. If they use hedge strategies, call them hedge funds.

Performance across the sector over three years is better, with 11 of the 13 funds that have been around for three years or longer notching gains. Ruffer Absolute Return and Threadneedle Absolute Return Bond are the stand-outs, managing 43.8% and 25.5%.

So do these funds need longer to produce the goods, or are the more established funds simply better than newcomers?

Absolute return funds do have a better track record over three years, but this is quite misleading, says Connolly. They performed really well during the 2009 stock market rally, but the real test is when markets are falling or trading sideways (like now), otherwise you might just as well have an equity fund. It is also true that many of the long-term outperformers invest in bonds, not stock markets, and bonds have enjoyed a far better time. Modray adds: The jury is still very much out.

But even backing established names may not help. Modray liked theCazenove UK Absolute Target fundbecause it is managed by Tim Russell, a cautious manager who successfully ran several other Cazenove funds but it has lost almost 5% so far this year.

Most funds charge a standard annual management fee of 1.5%, plus fees of up to 20% of any outperformance, which Modray says is bordering on daylight robbery. A performance fee might be all right if managers charge less during periods of underperformance, but they charge the same regardless its basic greed.

Gartmores Pursglove argues that performance fees give a manager an incentive and align his or her interests with the client.

Connolly, despite his criticisms, does rate a handful of funds: We likeBlackRock UK Absolute Alpha,Newton Real Return, and Standard Life Global Absolute Return Strategies. But investors should not have a large exposure, and many should have no exposure at all.

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