Fraser Donaldson, Defaqto’s Fund Research Head, summarized the main pros & cons of investing in Absolute Return Funds in his 2009 Guide to the Sector:
Like all UK mutual fund investments, the value may fall as well as rise.
The sector has been increasingly popular through 2009, particularly the second half of the year. With so many nuances to it, Defaqto believes that Advisers looking at putting their clients into Absolute Return Funds should pay particular attention to a number of questions (listed below) which they wouldn’t ordinarily associate with Fund Selection in a more established sector.
Q1. Where does the fund invest?
A1. There are several routes to the answer to this question. Firstly, is it a UK, European or a global fund? Secondly, is it an equity fund, bond fund or a combination? Thirdly, does it invest only in derivatives or use derivatives to support or hedge other investments. The asset allocation needs of the investor and the risk profile must be considered carefully. If absolute return techniques are only being used to support direct equity or bond investment then that may affect the risk rating of the portfolio construction.
Q2. Over what time frame does the manager expect to beat his target?
A2. This may be 12 months or it may be a greater period. Whatever the answer it is important to ensure that the time frame suits the investor’s requirements and matches the risk profile. The performance table shows fairly large falls – check the time frame!
Q3. What experience do the manager and the investment house have in running alternative strategies?
A3. Alternative strategies have been used for some time in institutional funds, it is only in recent years that the techniques have been available within retail funds. Consequently the house may have great experience in running such funds to give confidence in the advice process to the investor. As the funds can invest in many asset classes it is important to know that the manager has the knowledge of all departments at his disposal.
Q4. If the return is absolute, does that mean it is guaranteed?
A4. No, the fund value may go down as well as up. Any investment is a risk and there is no guarantee that the manager will meet the target set. Guaranteed or protected funds are available but they come at a cost and do not ensure growth, but merely target preservation of capital.
Q5. Wasn’t it the use of derivatives that caused the banking crash?
A5. Not in the same way. The derivatives used in absolute return funds replicate a collection of shares or whatever the particular trades are, it could be bonds or currency, and the risk is to whether or not price goes up or down. The problems with the banks started when mortgages given to risky borrowers were not repaid as expected and the value of the houses supporting them dropped.
Q6. Do managers sell shares they do not own?
A6. Not exactly. The UCITS rules do not allow managers to sell (or short) shares they do not own but there is a way that they can replicate such a transaction by buying a Contract for Difference. This is sometimes known as “synthetic shorting” whereby the manager will arrange a deal when it is believed that the price of the share will fall.
Q7. What is a performance fee and why should it be charged?
A7. A performance fee is made if the growth of the fund beats an agreed target (hurdle). The fee is usually a percentage of the growth above that level. The fee is made to incentivise the manager to work carefully on behalf of the investor. The investor will already have made a reasonable gain before the fee is levied. This methodology means that the manager and investor goals are aligned. The argument against is that the manager may stray from his usual process or take additional risk to achieve the performance fee hurdle.
Q8. Some fees are 20 per cent. That sounds high!
A8. The charge of 20 per cent is only levied on the growth of the fund over the hurdle rate, it is not charged on the value of the fund like an annual management charge. If the manager does not meet the hurdle then the fee is not paid.
Q9. A number of the funds invest in other funds, does this increase risk?
A9. Like all fund of fund investing the risk is reduced as the investment is spread more thinly. An absolute return fund of funds can invest in funds that retail investors cannot so giving a greater opportunity for positive returns.
Q10. Does it matter that the fund is not in the IMA Absolute Return sector?
A10. Not at all. The manager can elect as to which sector the fund is shown in. There are no asset allocations in the AR sector unlike most of the others so no comparison can be made. If the manager elects to put the fund in another sector the fund will be monitored to ensure that the underlying investments meet the sector criteria.
All information is copyright Defaqto Limited 2009.
Excerpt taken from Defaqto’s Official Research Guide to Absolute Return Investing 2009. To find out more about Absolute Return Investing and Defaqto’s Official Intermediary Research Guides and Reviews, click here