esponding to my recent post aboutbuying government bondsfor diversification, a reader asked if Id considered using

I have, but only superficially; Im far from an expert in either kind of fund, but I dont particularly like whats on offer, especially as a replacement for bonds.

In this post Ill consider absolute return funds. Hedge funds well look at some other day, perhaps when Ive grown less jealous of the anti-hero hedge fund manager John Veals in Sebastian Faulks new novelA Week In December, who seems to have a whale of a time throughout the book.

For now heres an overview of absolute return funds, what theyre meant to do, and why theyre not a substitute for government bonds.

Absolute return funds can simultaneously go both long AND short equities or other assets, with the aim of providing a positive return, regardless of whether the stock market goes up or down.

I consider them a sub-class of hedge fund, although the legal definition may be slightly different.

The basic principle of how absolute return funds work is:

on the market, he might have say 70% of the funds money in shares, and 30% in short positions that will gain if the market falls.

these figures could be reversed, so he will gain more from the market falling. He is hedged with his long positions, should he get it wrong.

In reality, the funds exact holdings will often be more diverse and complex, and they can use other hedging techniques, too, such as derivatives.

The net result of the long/short strategy is meant to be a positive return, regardless of the markets direction.

Of course, this only workswhen the fund manager predicts the direction of the market correctlyand so gets his long/short allocation right.

Because this is very difficult, some absolute return funds only aim for a positive return over rolling three year periods. This way, even if the manager gets it wrong for a while, the returns are smoothed, and his long/short hedge strategy should prevent the damage being too burdensome in any one year.

The targets can be more complicated. S0me funds might look to beat the returns on cash + x% every year, where x varies depending on the testosterone levels of the manager.

Presumably such funds will need to hold a lot of cash or fixed interest to be truly confident of doing this in terrible years or maybe they simply close the fund if and when they fail. (Cynical?Moi?)

Absolute return funds are theoreticallymost useful when the market is falling, since few investors go short shares or the market, and are thus very exposed when a bear market strikes.

In contrast,absolute return funds will generally under-perform in rising marketsdue to their hedges working against their gains.

A manager who is exceptionally skilled or lucky at picking both long positionsandgoes short assets that decline even as the market risesmaybeat a rising market, but Id put the chances of a regular repeat performance at zero.

But thats not really a criticism these funds are not meant to beat the index in both good and bad years. They are simply meant to provide a positive return for risk averse investors.

Many absolute return funds are pretty new (well see why below) so theres not a lot of data on their returns.

But according to a report on 2008 by Chelsea Financial Services (quotedhereinThe Guardian):

Only five of the 19 funds with a one-year track record made positive returns last year. 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.

Its a similar story according tothis articleonThe Motley Fool UK. It uses data fromTrustnetto find the average absolute fund lagged the UK stock market index until 2008, then smashed the market with a -1.8% return that year, versus -29.8% for UK shares.

Again its not the absolute return were promised although I doubt many absolute fund holders would complain if you compare it to the FTSE!

Obviously some absolute return funds did a lot better than average SVMs Saltire fund apparently grew by nearly 20% in 2008 but then were down to the old problem of selecting the winners in advance. Very hard, or arguably impossible, so you have to consider the whole class I say.

Like all financial types who get a whiff of the cookie jar, absolute return fund managers arent shy of charging high fees.

These fees differ from fund to fund, but 2% a year plus performance fees are pretty standard.

The managers sometimes have some hurdle (say the return from Government bonds, or a flat 5%) that they have to meet before the performance fees are payable. As ever, check the small print.

The main point is that these funds are expensive to hold versus the 0.5% annual charge of a typical UKindex tracking fund. And its even cheaper to hold government bonds once youve paid your dealing fees its free!

A 1.5% a year difference might not sound like much, but if the tracker and the absolute return fund both returned an average of 10% a year before fees on an initial 100,000, then after 20 years:

The absolute return fund, after 2% fees, would be worth: 466,096

Subtracting another 2% to reflect performance fees leaves: 320,714

In contrast, the trackers 10% a year minus fees gives: 614,161

An absolute fund manager would argue that the absolute return fund holder has suffered less volatility and has fewer grey hairs as a result, which was presumably what they wanted.

And thats true, though as weve seen these funds still decline in steep bear markets.

But the potential differences in outcomes does outline highlight how expensive such protection from volatility is.

Remember, too, Im assuming both trackers and funds even out to each return 10% a year.

In reality, Id bet folding money that the tracker would win even before charges over two decades, assuming reinvested dividends.

Lets return to the original question could you hold these funds to reduce volatility as opposed to government bonds?

The return from government bonds in 2008, according to theBarclays Equity Gilt Study, was:

Compared to the deep bear market for equities in both the US and the UK, thats a stunning result definitely what Id call an absolute return!

Its also rather better than the -1.8% return from the average absolute return fund, although theres no guarantee bonds will do this well in all bear markets.

Absolute return funds may hold bonds, of course. And to be fair, even asimple portfoliosplit 50/50 between equities and gilts would still have seen an overall loss in 2008, despite its relatively huge government bond weighting.

However charges would be a lot less, as weve seen (0.5% for the equities and zip for the gilts), and youd still see a lot of growth in the good years. The whole point of such asset allocation is to create sort-of-absolute returns, after all.

In conclusion, I dont see any merit in holding say 20% of my wealth in absolute return funds, versus government bonds. It would probably reduce volatility, but not by much given Id still have 80% in straight shares and it would definitely see more of my money going into fund managers pockets.

Absolute return funds may make more sense if you put virtually all your money into them (spreading it between several such funds). This way your allocation to the funds is big enough for their return to dominate your performance.

As weve seen already, though, you pay a high price for handing over responsibility and avoiding volatility, through both fees and mediocre performance in the good years.

Id rather wait for agood price for government bonds, and split my money between equities, bonds, and cash as I see fit myself.

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Hey Mate Great overview! One really should think about absolute return funds in markets that arent raging bulls. The fund manager only gets paid when they make money, and not when they outperform.

Absolute return funds may just be the answer, or partial answer for asset allocators for little guys.

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