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Published:16:47 GMT, 7 August 2012Updated:17:08 GMT, 28 June 2013

A fresh barrage of criticism has been unleashed against absolute return funds just as the City watchdog weighs up its verdict on their risks.

The funds have attracted investors because they aim to deliver positive returns under any market conditions – but have been slammed for complexity, high costs and poor performance by financial advisers.

They were flagged up as a potential concern by the Financial Services Authority in its last risk outlook report in March, and it is now probing the sector further.

Flexible approach: Absolute funds aim to deliver positive returns under any market conditions

The FSA is carrying out work to assess the extent of the risk posed by absolute return funds – although this falls short of a full-scale investigation – and it plans to release an update in the autumn.

The Investment Management Association is also looking at overhauling the way strategy-based absolute funds are classified in relation to traditional asset-based investment fund sectors, but it doesnt expect to deliver findings until the end of 2012 at the earliest.

We have been calling for the mis-labelling of absolute return funds to be investigated for the past two years and we are delighted that the FSA has finally started to address this, said Alan Miller, co-founder of investment manager SCM Private.

Absolute return investing is when a fund manager tries to achieve a positive return no matter how well or badly markets are performing.

They might invest in a wide variety of ways to achieve this goal – including shorting or making a bet that an asset will fall in value.

The volatility of stock markets since the financial crisis began in 2007-2008 has prompted more investors to take an interest in the sector.

The current IMA label does little to avoid mis-leading consumers and it claims that absolute return funds will aim to achieve positive 12 monthly returns in ALL market conditions.

This is yet another example of how the IMA has been ignoring consumers best interests and does little to encourage consumer confidence in the products they are buying.

Miller claims that absolute funds are not transparent and net return figures conceal a host of fees and performance charges that prevent investors from making informed decisions.

And he added: We doubt absolute return investors really understand how the combination of high performance fees and other costs savage their investments.

Research undertaken by SCM Private as far back as December 2009 showed that up to 55 per cent of underlying performance from absolute return funds can be extracted through various fees and charges.

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Only three out of 51 absolute return funds are worth considering, according to financial adviser Informed Choice.

Henderson Credit Alpha, Insight Absolute Insight and Newton Real Return received acceptable scores under its screening model- representing less than 6 per cent of the total sector.

But 67 per cent of funds in the sector scored less than half, when factors including consistency and cost were assessed.

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, said Informed Choice chartered financial planner Martin Bamford.

Our fund selection process seeks to identify funds that demonstrate consistent risk managed returns combined with low total expense ratios [TERs, the standard industry yardstick of total fund costs].

ICs study revealed that two thirds of the funds in the absolute return sector had a TER of of 1.6 per cent a year or above and a quarter had a TER of more than 2 per cent a year.

Bamford added: So far this year we have seen regular bouts of stock market volatility as fears over the eurozone sovereign debt crisis continue. Absolute return funds should have been able to profit from these trading conditions, yet they fail to deliver consistent risk adjusted returns.

Investors need to think very carefully before including absolute return funds in their portfolios. Failure to perform and high costs make them a less appealing option than a well constructed and regularly reviewed portfolio of suitable funds.

IC said that absolute return funds use a variety of strategies to target real returns regardless of market conditions, and often appeal to investors during volatile times in the belief they can profit from falling or rising markets.

Vital stats: Absolute return fund sector performance over five years (Source: FE Trustnet)

Financial advisers stand between investors and funds, and if they believe absolute return funds are too complicated or not performing it is up to them to decide whether to suggest them as an investment,says IMA spokeswoman Mona Patel.

If advisers are concerned, I wouldnt expect them to recommend them to their investors, she said.

Patel said that all funds outline their charges so that investors can compare them, and the TERs or ongoing charges figures on absolute return funds were not more complicated than any others.

Performance fees – which were only paid for outperformance – and entry and exit fees were charged separately, she added.

The current IMA definition of the absolute return UK sector is: Funds managed with the aim of delivering absolute (i.e. more than zero) returns in any market conditions. Typically funds in this sector would normally expect to deliver absolute (more than zero) returns on a 12 months basis.

Commenting last June on its review of the sector, the IMA said: As well as considering redefinition and division of the sector, the IMA wants to group these new style returns-based funds coherently alongside its more traditional asset-based sectors.

In the context of a low interest rate environment and with concerns about volatility in the markets, investor demand for returns-based, or outcome orientated, funds is set to grow. These funds, like all UK-authorised funds, are subject to extensive regulation.

Sub-divide the existing sector to indicate which funds are targeting more stable outcomes.

Sub-divide the existing sector by hedge fund style categories such as long/short [buying long in the expectation an asset will rise in value, as opposed to shorting in the expectation it will fall].

Retain a single sector and let it continue to grow, but rename and redefine it and supply additional information on the IMA website to allow users to filter by a number of criteria such as assets, investment strategy and SRRI rating [synthetic risk and reward indicator, which assesses the risk of a funds assets on past volatility].

The FSAs Retail Conduct Risk Outlook report in March gave four reasons why absolute return funds could pose risks to investors:

Consumers may not understand understand them. For example, they may believe there is an element of capital protection, or guarantee of a positive return.

Consumers could suffer significant unexpected financial loss if they are sold funds that fail to perform, and where the perception mentioned above continues to exist.

The complex strategies and structures employed in absolute return funds could be more difficult to understand than those found in traditional long-only funds [see long/short explanation above].

Financial advisers may not fully understand these products, which increases the possibility that poor communication of investment risks contribute to mis-selling to consumers.

The FSA says it is carrying out work on the potential risks and will report back this autumn.

Fund watch: FSA showed absolute return fund performance for last year in its risk outlook report

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