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Absolute return funds offer a less volatile investment option for default DC pension funds, but they do have their drawbacks.

Absolute return funds (AFRs) have grown in popularity on the back of volatile equity market performance.

ARFs are relatively expensive and, despite their name, can still lose money.

Employers tend to use ARFs in conjunction with a more passive fund for their default investment option.

Absolute return funds (ARFs) have grown in popularity among employers seeking less volatile investment returns for their default defined contribution (DC) pension scheme members amid the bearish equity markets of recent years.

ARFs are considered much less volatile than equity-based funds, in which DC funds have traditionally been invested. Stephen Bowles, head of DC at Schroders, says: Since 2008, we have witnessed first-hand how volatile equities on their own can be, and people have looked for other solutions. In the 1990s, everyone focused on growth, but through the second half of the 2000s and beyond, [the focus] has moved back to be more balanced.

Andy Dickson, investment director at Standard Life Investments, adds: Trustees are using ARFs because they recognise that they cannot do what they used to do and need to work out a broader range of opportunities.

Growth is good, but we needed to manage the risk we were exposing members to as well, which meant we looked at these types of solutions because they are better capable of managing that risk element, and getting a better compromise between growth and the risk that is inherent in any investment.

ARFs aim to deliver positive investment returns to investors above those they may have received from their bank account irrespective of market conditions, but they do not typically guarantee to do so.

Each ARF has its own cash plus rate, which is the return it aims to deliver to investors. Fund managers often use a benchmark rate, such as the London interbank offered rate (Libor), to set this rate. For example, BNY Mellon Asset Managements Newton Real Return Fund aims to deliver a cash return of 4% above one month Libor per annum over five years, before fees.

BNY Mellons fund, together with Standard Lifes Global Absolute Return Strategies (Gars) fund, is one of a number of popular ARFs to have launched in the last few years. According to the Financial Services Authority (FSA), the number of ARFs in existence has risen from 17 in 2008 to 78 as at December 2011.

ARFs typically invest in a multi-asset portfolio. Dickson says: Good strategies have a very careful mix of diversified investment opportunities, so they dont just invest in traditional areas, such as equities and property. They invest in a much wider range.

The downside of ARFs includes cost: these are typically twice as expensive as other types of default fund. So employers typically use ARFs in conjunction with passive, low-cost funds. For example, Volkswagens pension funds ARF constitutes 50% of its default fund.

Paul Kemmer, managing director at P-Solve, says: Some ARFs are actually highly correlated with underlying markets, such as the FTSE. You can be paying 1-2% base fees plus performance fees, which could be 10-20% on top of that. You dont mind paying it if you get strong performance, but if you dont, you would have been better off to invest in the FTSE.

The FSAs Retail conduct risk outlook 2012, published in March, found 51% of ARFs made negative returns in the year to January 2012.

Laith Khalaf, pension investment manager at Hargreaves Lansdown, says: Although they aim for absolute returns, they are not guaranteed, so investors need to be aware of that. Also, if we have a more vibrant stock market than we do at the moment, these funds are likely to fall behind the traditional equity-based funds.

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