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Are absolute funds an absolute waste of time?

Absolute return funds aim never to fall. In choppy markets the appeal is clear but do they succeed?

Nine of 61 absolute return funds lost money over the past year, despite the FTSE 100 rising by 16pc

Most private investors have heard of Neil Woodford but have you ever heard of Guy Stern? Mr Sterns fund, Standard Life Investments Global Absolute Return Strategies, which he runs with his team, has just overtaken Mr Woodfords famous Invesco Perpetual High Income fund in terms of fund size.

Remarkably, the Standard Life fund is just four years old, whereas Mr Woodfords stalwart opened for business in 1988.

The Standard Life fund, often known as Gars, is the biggest of the new breed of absolute return funds, which aim to deliver positive returns to investors whether markets rise or fall.

Its not hard to see why investors have flocked to them in recent years, when share prices have plunged repeatedly with each new phase of the financial crisis.

Even a manager as good as Mr Woodford, by contrast, will see his portfolio knocked in a stock market sell-off when all shares are dragged down.

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But are investors making a canny move if they seek to limit their losses by buying absolute return funds? Or would they be better off with a good conventional manager who will, over the long term, pick the stocks that deliver rising income and capital growth?

According to detailed research published by a firm of financial advisers last week, only three absolute return funds are worth considering. This represents just 6pc of the sector of 51 funds.

Informed Choice looked at a range of factors, including performance, consistency and charges, awarding funds a total score out of 100. It decided that only funds that scored more than 80 should be considered by investors, and the three funds that managed this were Henderson Credit Alpha (with a score of 92), Insight Absolute Insight (81) and Newton Real Return (80).

Two-thirds of the funds received a score of less than half the maximum possible.

Martin Bamford, of Informed Choice, said: Absolute return funds are regularly criticised for their poor performance and high costs. This research demonstrates that criticism is justified for the vast majority of funds in the sector.

Our fund selection process seeks to identify funds that demonstrate consistent risk-managed returns, combined with low total expense ratios. Absolute return funds have never been a comfortable fit with our investment philosophy and this research shows that they offer very little that should attract investors.

Mark Dampier of Hargreaves Lansdown agreed. These funds have been a grave disappointment, he said. They havent lived up to their name.

He particularly dislikes the fact that many absolute return funds impose performance fees and that these charges can be triggered even when performance has been lacklustre.

Sometimes these fees have been imposed when returns have failed to beat inflation, or for a period of good performance that has promptly been reversed, he said. There is no clawback when this happens, of course. The way these performance fees work is usually far from transparent, and they can be equivalent to annual charges of 4pc.

Robert Pemberton of HFM Columbus said: A lot of funds in the sector have lost investors some of their money over the last year and are not worth consideration.

Many successful investors say dont buy anything you dont understand. In seeking to defy market gravity, some absolute return funds employ complex and often incomprehensible strategies.

Try this extract from a recent update on Standard Lifes Gars fund: We closed the broad market exposure as well as the long Eurostoxx exposure. Instead, we opened a new short position in European senior financials, meaning the new strategy is long exposure to subordinated financials credit, and short senior financials credit and bank equity.

Now look at the prospectus for Mr Woodfords fund: We continue to focus the portfolio on what we believe to be fundamentally cheap companies, many of which are defined as blue-chip and where we believe valuations continue to underestimate their ability to grow through a prolonged period of economic stagnation.

Most investors will find Mr Woodfords approach a lot easier to understand.

While Gars, in common with many other absolute return funds, uses derivatives to short particular assets, others use different means to achieve the same ends. Some do not use any shorting, instead investing in a mix of asset classes to minimise the chances of sharp falls across the portfolio as a whole.

The absolute return sector is a mishmash of funds encompassing a wide divergence in asset class composition, style and methodology, making comparisons a potentially dangerous exercise, said Mr Pemberton. The giant of the sector is Gars, which has produced impressive returns over the last few years but which we do not recommend to clients, as I find its methodology rather complex.

Mr Dampier said he had bought the fund, which doesnt levy a performance fee, but only after taking the time to understand it. Its vital to take your time, do the research, look under the bonnet of any fund to understand the objectives and its track record. Ive had this fund over a few years of very difficult markets and its done a reasonably good job, he added.

Dont be driven by the name of the fund or the sector it belongs to. I own three funds that have similar aims its always good to diversify but one of the others, Troy Trojan, is classed as flexible investment, although it has the same capital preservation aim. His third fund is Newton Real Return, which is also tipped by Adrian Shandley of Premier Wealth Management.

Mr Pemberton said the key question when looking at any fund was what is its objective and is it likely to be attained? He added: For an absolute return fund I would expect to see it preserving investor capital on an annual basis over the long term as well as producing an annual return at least a couple of percentage points higher than they would get in a savings account.

The sector is irrelevant. We recommend four funds that over the past decade have achieved this objective in very difficult market conditions: Troy Trojan, Ruffer Total Return, Miton Special Situations Portfolio and Newton Real Return. These funds are all conservatively managed multi-asset funds of which only one, Newton Real Return, is actually in the absolute return sector.

Mr Bamford recommended a diversified portfolio of funds such as M & G Strategic Corporate Bond, Royal London UK Index Linked, Rathbone Income and Aberdeen Emerging Markets.

One adviser expressed concern about the growing size of the absolute return sector. Alan Steel of Alan Steel Asset Management said: I am alarmed at the inflows to this sector and this [Gars] fund by folks who should be more careful. Many advisers admit that they dont know how the fund is constructed.

In March the Financial Services Authority said absolute return funds were of potential concern. A spokesman said the regulator was worried about the growth of the sector, the possibility that investors would think that positive returns were guaranteed and the danger of investors and advisers not understanding the funds. It expects to publish the conclusions of its review later this year.

A spokesman for Standard Life said: The Gars fund was built for scale, it could be much bigger than it is now. We have absolutely no thought of limiting inflows. Mr Dampier said the size of the fund was not yet a problem, as it had 30 different trading strategies that were uncorrelated with each other.

He was more concerned about the sectors future performance. The danger is that markets will take off and these funds will be left behind.

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