A safe bet or a languid investment scheme?

THEY promise steady growth and protection from market volatility, but doubts linger over the ability of absolute return funds to deliver.

Three more absolute return funds were launched last week, capitalising on demand for returns regardless of market conditions. Investors seeking some protection from market turbulence last year ploughed millions into absolute return funds, which target positive returns by using a variety of investment strategies to minimise downside risks.

The average fund in the sector grew 9.12 per cent last year, compared with FTSE growth of just over 30 per cent. Yet the previous year, the typical absolute return fund was down just 0.54 per cent, while the FTSE All-Share was down almost 30 per cent.

But while absolute return funds are increasingly popular, many have failed to meet their objectives. While the average absolute return fund has delivered positive growth in each of the past three years, several have lost money and the variation of returns can be wide. Over the past 12 months the best fund – the CF Octopus Partner Absolute Return – is up 32 per cent and the worst (the Elite LJ portfolio) has fallen 0.6 per cent.

So for cautious investors considering dipping into absolute returns, there is plenty to mull over. Not only are there very different types of funds under the absolute returns banner, but there's a lot of jargon too.

The funds were first offered to private investors some five years ago after changes in investment regulations allowing managers to use techniques, such as shorting (betting on a share price falling), that were previously limited to institutional funds. Now there are nearly 40 funds in the Investment Management Association (IMA) absolute returns group and their number is swelling rapidly. Last week Aegon joined the party with its UK Absolute Return Equity fund, just days after Legal & General launched UK and European absolute return funds.

Adrian Lowcock, senior investment adviser at Bestinvest, said: "Most aim for long-term positive returns regardless of market conditions, therefore in rising markets they may lag an equity index but provide gains in flat or falling markets. As such, they are very useful for investors to help provide long-term performance whilst giving protection should markets fall."

However, the absolute returns label covers a broad range of fund objectives, investment strategies and risk levels, making it difficult for investors to make comparisons, said Juliet Schooling Latter, head of research at Chelsea Financial Services. "You need to look at them carefully because some absolute return funds are stock-based and some are multi-asset or fixed interest, while some are UK-focused and others invest globally," she said.

For example, while the Standard Life Global Absolute Returns uses assets including shares, bonds and money market instruments, some invest primarily in bonds, such as the Baring Absolute Return Global Bond fund.

The latter is up 12 and 21 per cent over the last one and three years respectively, while the Standard Life offering, launched in May 2008, has returned 22 per cent over the last year.

Perhaps the best known is the BlackRock UK Absolute Alpha fund, run by Mark Lyttleton, which invests in UK equities and is among the funds to use derivatives allowing the manager to "short" stocks. "It won't set the world alight and it will lag a strong bull market, but it should provide downside protection," said Lowcock. "2008 was the test of that and it didn't lose anything."

Expert opinion regarding the effectiveness of the absolute returns approach is mixed. Many advisers believe investors are better off diversifying across the main asset classes – equities, bonds, cash and property – than relying on safe haven funds such as absolute returns.

Critics of the approach also point to a lack of transparency that makes it difficult for investors to understand how their money is invested and the level of risk they are taking. Their mixed performance record has also undermined the appeal of the funds and Schooling Latter warned that the youth of the sector means few funds have long-term track records available for credible comparison.

"Some don't even have a year's track record so it is very important for investors to go for a manager with a strong reputation and experience in shorting," she said.

But Graeme Forbes, chartered financial planner at Intelligent Capital in Glasgow, believes the downside protection built into absolute return funds is increasingly attractive.

"Expecting shares to bail us out 'in the long run' is no longer dependable," said Forbes. "This type of fund aims for a consistent positive return in almost all market conditions. Overall, we are able to search for broader balance, steadier accrual of investment returns and lower downside risk."

Forbes recommended the 7IM, Elite Hasley and JP Morgan funds. "We think that investors need to be reconditioned to accept steady, incremental growth rather than the rollercoaster ride that characterise three of the four main traditional assets classes."