bsolute return funds, which aim to make money for investors in rising and falling markets, are enjoying a flurry of activity. Half of the 20 funds in the sector have been around for less than a year, three have been launched in the past month – by SVM, Gartmore and Argonaut – while Pictet has said it is planning one and a number of other fund managers are considering joining the fray.

There are three key reasons for the flood of launches. First, managers have only recently been allowed to use techniques such as shorting in retail funds. Second, with stock markets down 40% in the past year and some pundits predicting further falls, it makes sense to launch a fund that claims to be able to make money for its investors even when share prices are falling. Third, there is evidence from companies such as BlackRock – whose UK Absolute Alpha fund was one of the best-selling retail funds last year – that there is retail interest in buying these products. So should you join them?

Iain Stewart, manager of the longest-running absolute return fund – Newton Absolute Intrepid, launched to institutional investors in 1993 – thinks this will be the future of fund management. He has run the Newton Exempt pension fund since 1992 and, back then, the trustees aim was to beat wage inflation.

That was how pension funds were structured then. The 25-year bull market has made people think they can own any random collection of assets and still make money. But the environment now is very different.

With virtually every class of asset except gold plummeting, making money will be far harder. These days, absolute return funds aim to give a better return than holding cash – which doesnt sound that hard given interest rates are so low. They aim to do that by using the powers for shorting stocks – that is, selling shares they do not own in the hope that the price will fall – and other hedging techniques that are now open to conventional fund managers under European directives.

Stewart, for example, uses what is called a multi-asset approach – which means he can invest in a wide range of asset types – and invests directly, rather than through funds.

We run the fund as an old-fashioned portfolio. A group of generalists look at the world and tailor the portfolio to the world we see. We buy specifics – for example telecoms, defence and pharmaceuticals at the moment. We do not own the market.

He is not afraid to resort to cash when that seems the best option.

BlackRocks UK Absolute Alpha and SVMs UK Absolute Alpha, which will be formally launched on 11 March, invest only in UK equities; Gartmores European Absolute Return fund and Argonauts European Absolute Return fund will use similar techniques in European equities; Henderson SG, Scottish Widows and Threadneedle offer absolute return bond funds that invest in the global bond market; companies such as Standard Life and Marlborough share Newtons multi-asset approach. What all do share, however, is a use of derivatives and hedging techniques to enhance the return during bear markets such as this one, and to protect the value of investors capital. That, at least, is the theory, but does it work in practice?

All the managers stress that investors should not expect the funds to make money for them month in, month out; but over the medium term – say three to five years – they should produce positive returns. They also warn that, while they should do better than conventional funds in a bear market, they may lag well behind them in a raging bull market. Darius McDermott, managing director of Chelsea Financial Services, likens them to what with-profits insurance policies were supposed to provide – relatively safe reliable returns – but which most have recently failed to achieve.

Few retail absolute return funds have long enough records to judge whether they can achieve that. Newtons is about to come up to its five-year anniversary and has produced an average annual return of more than 22% since launch; BlackRocks is about to celebrate its third birthday and has returned 18.44% since inception.. SVM says its new fund will mirror its exiting Saltire fund, which has averaged 12.7% a year since it was launched in 2002, capturing 80% of the rise in the markets but protecting against the downside. In 2008, for example, it grew 19.7%, while the market fell 29.9%.

But not all absolute return funds are that consistent. Only five of the 19 funds with a one-year track record made positive returns last year, according to statistics produced for Cash by Chelsea. While most lost less than 10%, so beating the rest of the market by a considerable stretch, that still does not meet most investors perception of an absolute return fund.

Even admired managers can have bad patches: Lyttleton had a difficult autumn as his bet on oil companies failed to pay off but a portfolio restructuring has improved performance since then.

These funds are expensive, so the onus is on the managers to justify their fees. Most will charge a flat annual fee of around 1.5% plus a performance fee, which is generally 20% of the return above Libor – the interest rate that banks charge each other. McDermott says that investors should ensure this performance fee has what is known as a high-water mark: that is, if it falls in value, it must make up these losses before the performance fee kicks in again.

Adrian Lowcock, senior investment adviser at Bestinvest, adds: Investors should look carefully at the fund they invest in as the asset class absolute return will include hedge funds, which have a wide range of risk profiles and objectives. In the retail market, most absolute return funds aim to be cautiously managed and shouldnt take on too much risk.

If a fund promises exceptional returns then it will not be cautiously managed; likewise if it is cautiously managed it will underperform in a bull market. These funds should provide stable returns, form part – but not too large a part – of a well-diversified portfolio, and can be used to reduce volatility of a clients investments, helping maximise returns.

•This article was amended on Friday 1 May 2009. The quoted figure of 18.44% as the return for BlackRocks UK Absolute Alpha fund was not an average but the accumulated return since the funds inception three years ago. This has been corrected.