Promise of a return in uncertain markets sounds too good to be true, and Rob Griffin reports that for many of these controversial funds it is just that

Absolute-return funds may appear to be the perfect investment but there are widespread concerns that they are failing to deliver on their promises.

These controversial products have grown in popularity by seeking to make money in any market conditions by using a variety of asset classes and investment tools.

But an analysis of performance data reveals that many of these funds have actually made significant losses over the past few years.

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Fully 70 per cent of funds in the IA Targeted Absolute Returns sector are in negative territory over the past three months, according to Morningstar figures to 17 October.

In addition, more than a fifth are down over the past year, while the three-year figures show that nine out of 68 funds have lost money.

Patrick Connolly, a certified financial planner with Chase de Vere, believes these funds have failed to capitalise on equity market volatility.

The performance of absolute-return funds has improved but the sector as a whole is still not doing the job it should, he said. It still hasnt managed to earn the trust of investors.

He cites a couple of factors, including the fact that many of these funds are closely correlated to stock markets and end up losing money when these experience turbulence.

Even when markets rise, many funds achieve little more than cash-like returns and they do it with much higher charges, sometimes including performance fees which are earned for beating a notional benchmark which could be less than 1 per cent per annum, he said.

Matthew Harris of Dalbeath Financial Planning also has reservations about putting clients into such products.

We dont like relying too heavily on individual fund managers, and absolute-return funds are very biased towards their skill or luck, he said. Were not confident in predicting which will be successful so prefer not to put them into portfolios.

Instead, he prefers to use a mix of traditional asset classes, the percentage of each depending on the amount of risk someone wishes to take. If a client wants a lower level of risk, for example, then we would alter the mix of asset classes and consider putting in more shorter-term corporate bonds, heexplained.

However, other industry figures are more positive. Darius McDermott, managing director of Chelsea Financial Services, believes there are some funds that are worth a look.

Absolute-return funds are a very good portfolio diversifier and an option for investors who may be worried about markets but are wary of fixed-income when interest rates could soon be rising, he said. They are often misunderstood, however, as they can appear more complicated than many would like. Some are very complicated, but others are quite simple.

There are more than 90 funds in the IA Targeted Absolute Return sector which aim to deliver positive returns in any market conditions, although returns arent guaranteed.

The funds must state the time frame over which they aim to meet their stated objective, and this period must not be longer than three years.

According to Gavin Haynes, managing director of Whitechurch Securities, there is a significant disparity in the risk profiles, fund structures and investment aims of funds. The breadth of investment means you cant compare one fund with another or view the sector as a realistic benchmark, he said. You need to drill down to understand how the funds work, what they invest in, and the risks they are taking.

This is crucial. Strategies range from fairly straightforward long/short approaches, where managers grant long positions to stocks expected to appreciate and short positions to those predicted to decline, to complicated approaches embracing derivatives.

This is why its impossible to carry out a detailed like-for-like analysis. Prospective investors need to make a call based on what a particular fund is trying to achieve.

Some funds have delivered solid returns over different time horizons. City Financial Absolute Equity, for example, has a fundamental equity long/short strategy that aims to achieve a positive absolute return for investors over rolling 36-month periods.

This fund mainly invests in UK and global equities and has delivered an impressive 102.6 per cent over the past three years, according to the Morningstar data.

Justin Modray, the founder of Candid Financial Advice, said it was important to consider funds on a case-by-case basis. Investors need to understand what its trying to achieve, how its constructed, and how correlated it is to stock markets, he said.

Mr McDermott at Chelsea Financial Services likes the Church House Tenax Absolute Return Strategies fund.

Its a small boutique fund run by two very experienced managers thats an extremely useful portfolio diversifier, he said. It is one of the few that targets an absolute return from diversification and risk management alone and doesnt sell securities or indices.

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