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How to find alpha even in a storm

ABSOLUTE return funds claim to offer the Holy Grail of fund management, by delivering positive returns regardless of whether markets rise or fall. It’s a great pitch, and there has been a spate of new launches. But is absolute return really that fabulous?

Absolute return funds work differently to conventional “relative return” funds, where the manager competes against a benchmark such as the FTSE All-Share. Traditional fund managers can claim success even if their fund falls, provided their benchmark falls further. But absolute return managers are expected to produce positive returns even in stormy markets.

Like hedge funds, absolute return managers try to generate alpha by taking both short and long positions. But while hedge funds are unregulated offshore vehicles, absolute return funds are available to institutional investors onshore, within a Ucits III structure.

When the IMA Absolute Return sector launched in April 2008, there were 15 funds. Now there are more than 40. Robin Minter-Kemp, managing director of investment funds at Cazenove Capital Management, which runs the Cazenove Absolute UK Dynamic and UK Absolute Target funds, says: “There is strong demand for absolute return strategies. Much of this comes from former hedge fund clients, who are attracted by the daily liquidity and separate custodians offered by a Ucits III fund, compared to a Cayman offshore vehicle.”

Institutional investors have used unregulated absolute return funds for years. “They can now access these funds in a daily dealing vehicle, giving greater flexibility and transparency, which should make the sector even more attractive,” he says.

The absolute return sector proved its merit during the recent crash, delivering positive returns over the last one, two, three and five years, according to Trustnet.com. It returned 14 per cent over the last three years, while the UK All Companies sector fell 7 per cent. But it underperformed last year’s dramatic rally, growing just 11 per cent when the UK All Companies bounced a massive 46 per cent.

Newton Real Return is the top performing fund over three years, growing 28 per cent, followed by Baring Absolute Return Global Bond (26 per cent), Threadneedle Absolute Return Bond (25 per cent), BlackRock UK Absolute Alpha (20 per cent) and Threadneedle Target Return (19 per cent).

Legal & General has just launched two new funds, its UK Absolute Fund and its European Absolute Fund. Head of distribution Hugh Cutler says absolute return funds give you low correlation to the equity market. “If global stock markets rise, conventional funds usually rise, and if markets fall, funds fall. Absolute return funds are different. They don’t move in line with traditional asset classes, which can help diversify your portfolio.”

He admits they aren’t cheap – institutional investors can expect to pay annual management fees of up to 1.5 per cent, often with performance charges on top. But Cutler claims absolute return is less risky than people believe. “With a skilful manager and reasonable risk management, you shouldn’t lose your shirt. Whereas if you had invested in conventional equity funds over the past decade, you would have lost it twice.”