goes in search of those absolute return funds that actually deliver positive returns.

What Investment goes in search of those absolute return funds that actually deliver positive returns.

Pinning down absolute return funds that actually deliver absolute returns can be a difficult exercise, not least because the IMAs Absolute Return sector is far from being a comprehensive listing. Created last year to reflect the growing number of funds that were adopting an absolute return strategy, it remains a voluntary grouping, and many funds that seek absolute returns also have specific elements to their mandates, such as a focus on a particular overseas market or region, and have opted to stay in those specific sectors for performance comparison purposes.

So what is absolute return? Put simply, it is making sure that investors returns are always positive, in contrast to relative returns where a fund managers performance is measured relative to a benchmark, usually an index such as the FTSE All Share. As Ian Stewart, manager of one of the longest-established and better-performing funds in the sector,Newton Real Return, observes, Absolute return investing has become rather popular lately, but you have to ask yourself, how did relative investing ever take hold in the first place? There really are a lot of vested interests in relative investing, and what people dont very often say to an asset manager is, Just make us a positive return.

And Tony Stenning, head of products at the UK retail fund management arm atBlackRock, generally regarded as being the pioneers of absolute return funds in the UK retail market, explains, Previously, when you were limited to long-only returns, you could outperform the market by ten per cent and still lose your investors 20 per cent, if the market was down 30 per cent.

One thing that quickly becomes apparent when looking at how absolute return funds are managed is that the whole process is bound up with a lot of jargon. Fund managers talk a lot about generating alpha (i.e. the element of fund performance that is attributable to the actions and skill of the manager) as opposed to beta (the return that comes from simply being in a particular market or asset class).

For example, Stenning says, For us, absolute return means using the alpha skills of the managers we have, and we struggle to see how you can do this without having a full range of specialist managers. The idea is to make a positive return in any and all market conditions, and you cant do that unless you have some managers that can make a positive return when some markets are falling.

This is where the concept of the absolute return fund is so appealing to fund managers and investors alike. The trouble is that setting out an investment policy that says you are going to deliver absolute returns and actually doing so can be two very different things.

The problem for investors is that there is no single definition of what constitutes an absolute return fund. Not only are they spread around several sectors, but they can also adopt widely differing investment strategies. Within the Absolute Return sector alone there are equity funds, bond funds, currency funds and multi-asset funds, each with their own absolute return target.

Caroline Shaw of investment managerCourtiersopines that Investors in these funds dont really know what they are getting. I would have thought that if you invested in an absolute return fund, you wont want much more volatility than cash.

She adds, Some are effectively hedge funds and others are bond funds. You have a disparate and diverse range of objectives. Some aim for cash plus a certain amount, others are LIBOR plus X and others simply seek a positive return. The objectives are so disparate, how can you compare like with like?

Ian Stewart explains, There is a whole range of different approaches, from the bond-plus approach, using fixed interest securities, where you are really looking for a stepped return, and the tactical asset allocation approach, to the growth approach and a variety of hedge fund strategies, and each one has its own risk characteristics. If you are aiming at cash plus four per cent or more, that will involve more volatility than, say, cash plus one per cent.

Of course, the basic principle behind these funds is pretty simple. Tam McVie, investment director for mutual funds atStandard Life Investments, makes the obvious point that Nobody would invest in anything other than cash if they thought that they werent going to get an absolute return. In that sense, all funds are absolute return vehicles.

But he adds, Where there is a big difference between what fund management houses call an absolute return fund and a traditional pool of risk assets is that the concept of risk is not determined relative to a benchmark. With an absolute return fund, that benchmark is cash, so the way in which you approach your investment strategy is very different.

Colin Harte, manager of theBaring Absolute Return fund, points out that One of the issues that you get is that there are very few things you can invest in that will give you this regular, positive return. Every now and then you are going to get a volatile period. What tends to happen when investors latch onto a particular asset class is that it gets quite expensive and you get quite a violent correction. That is what happened to credit last year.

Tam McVie puts it succinctly: Just because they are called absolute return funds, there is no guarantee that the returns they produce are going to be positive. Sheldon MacDonald, a senior investment analyst at investment houseNedgroup, observes that The degree to which absolute return funds deliver positive returns will depend

on how successful the fund manager is at following the strategy, but these funds should deliver better risk-adjusted returns over the longer term.

Indeed, a key element is the time frame over which the absolute return is supposed to be generated. Stenning observes, With regards to the time frame, the IMA defines it on the basis of a rolling 12-month period, and we hope to meet that. But with any investment fund, you should be looking at a medium- to long-term view, not just one year. These are not guaranteed products, and the skills of the managers are very important in terms of picking the right stocks.

Although some funds that now come under the general heading of absolute or total return funds have been around for some time, the dramatic recent growth in the number of funds following an absolute return strategy follows the introduction of the European-wide UCITS III directive, which gave authorised investment funds greater investment powers, including the ability to go short.

Tony Stenning recalls that It had always bugged me how, before the change in the rules in 2002, it was only ultra-high-net-worth investors who could get access to these sorts of absolute, uncorrelated returns, for that is what the early hedge funds delivered. The rule changes enabled authorised funds to go synthetically short, so we started discussing this at the end of 2002, but it still took until 2005 to get it off the ground. By the time

we got it to the market, we thought there would be a whole plethora of these funds out there, but the reality is that these funds are not easy to run.

The comparison with hedge funds is one that recurs frequently. Colin Harte admits that The sector does cover a very wide area. The problem with absolute return is that you have to boil it down to whether the manager is seeking to add to the beta he gets from a particular market. We are a bond and currency fund. There is an element of risk, but really, the way we run the fund is similar to a hedge fund, taking long and short positions.

He adds, This was the way that many hedge funds made their name. They adopted what you might call an absolute return style, where you werent just getting the beta of the assets you were in. In recent years, a lot of those funds have really just played the beta and come unstuck.

MacDonald argues, Last year was not a good one for hedge funds, but as people are willing to accept that last year was a special case, they will be willing to invest in these funds. You have to ask yourself the question, If the absolute return funds around at the moment are just hedge funds under another guise, why will they be

any more effective? I think you should say that last year was due to an exceptional set of circumstances that are unlikely to be repeated.

Certainly the performance numbers being generated by some of these funds during a volatile period for stock markets are very impressive. David Crawford, the manager of theCF Octopus Partners fundthat is currently showing a one-year positive performance in excess of 32 per cent, explains that It is a long/short UK equity fund I

go long when I am positive of a stock and short when I am negative.

He adds, Last year, I was generally short. I was short of banks, short of retailers, short of the leisure sector, short of housebuilders. This year, I have been generally long. Each stock idea has a price target and there has to be a catalyst to get to that price target. I try to hold until that target is met.

He adds, I am taking individual positions in individual stocks with specific targets set for each of those stocks. Where the fund differs from BlackRock, for example, is that I focus on individual stocks. If you take a more stock-specific approach, you will tend to go long of more stocks, and you will also tend to have more shorts when you are less positive. If you are more pair trading, then you will tend to have a market-neutral portfolio. Adopting our approach, you end up with higher volatility, but it also means that you generate a higher return.

Ian Stewart argues that the growth of absolute return investing reflects the way in which investment markets have changed. We believe we are in a much more volatile world, where asset prices will not simply keep going up as they did in the 1980s and 90s. In those circumstances, you have to be a lot more flexible, and an upward-only benchmark is a very useful focus to have when fixing your strategy. In a sense, it has become a bit of a lost art, as there arent that many people who invest tactically across asset classes.

And Tam McVie emphasises that What is important for all absolute return funds is that they are risk-seeking funds. If you dont want to lose money, then go into cash. But if you want to invest in risk assets, then this is a way of doing so, while also controlling the volatility.

We are trying to balance these off with things like short-duration bonds and government debt. This is what an absolute return strategy means. It is a simple idea, but one that is, nevertheless, quite difficult to put into practice.

Caroline Shaw adds, To me, absolute return means cash plus possibly as little as one per cent, but some of these things are generating much greater returns, so they must be taking much greater risks. The number of new launches indicates that people think that this is going to be a popular area in the future, but I would be worried about the volatility.

She asks, Do you really want to invest in a hedge fund, because that is what some of these things are? You think that you are investing in something that will give you a certain amount over cash and suddenly you find that you are in a long/short hedge fund with a currency overlay.

Colin Harte stresses that The key question for the investor to ask is, Does the manager spell out what he is trying to do? There are some funds that are very clearly defined in what they do, for example BlackRocks UK equity fund, but there are others that are run as multi-asset funds where you really dont know what you are getting.

And Sheldon MacDonald cautions, You need to be even more careful than you would be in choosing a traditional long-only fund. Even from the big houses, you need to know what they are going to do and what sort of instruments they will be using, and be sure that you are comfortable with that. It is extremely important that the investor understands what they are getting into.

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What Investment is the premier magazine in the UK for private investors, exploring opportunities across the market, seeking out the best funds, shares and ideas. We also look at the latest trends in wealth management and tax planning to give our readers a unique perspective in a fast moving world.

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What Investment is committed to exploring the best opportunities in the investment trust market. Investment Trusts are covered in every edition of the magazine, and in alternate months we delve into the best opportunities in our special investment trust section. Readers who have been with What Investment since its launch over thirty years ago regularly tell us that their subscription is one of the best investments they have ever made.

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