Absolute return (AR) funds are being touted as the safe place in an uncertain market – but novice investors should understand the pitfalls, writes CAROLINE MADDEN

WITH STOCK markets bouncing around like yo-yos, it’s no wonder absolute return (AR) funds – which aim to deliver the goods even if markets are tanking – are flavour of the month with investors.

However with the UK’s financial regulator now sniffing around this sector, and warnings being sounded about the potential for mis-selling, investors need to do their homework before following the herd.

AR funds are a marketeer’s dream. The raison d’être of these funds is to deliver positive returns in all market conditions so they can be pitched as “safe havens”, a phrase that is music to investors’ ears in these turbulent times.

This sales pitch has been going down a treat. Since January 2009 the European AR market has ballooned by 80 per cent. By March of this year, the amount of money being managed by this sector had reached €140 billion.

It’s easy to see why the chance to make money, whether markets rise or fall, has gripped investors’ imaginations. But is the AR sector in danger of becoming a victim of its own success by attracting increasing numbers of inexperienced investors who may or may not understand what they’re getting into?

Last month the credit ratings agency Fitch put the cat among the pigeons when it warned that the AR sector posed “an increased risk of mis-selling” to less sophisticated investors.

This is because of the lack of a commonly agreed definition for what exactly constitutes an AR fund. Of course Fitch has not exactly covered itself in glory, having been among those rating agencies discredited during the subprime meltdown, but it has a point.

AR funds all aim to grow your cash into a larger pile of cash, regardless of what’s going on in the markets, but the managers of these funds employ a huge variety of strategies in their quest to achieve this act of financial wizardry.

Many use complex financial products to “hedge” their positions against losses. Some aim to deliver positive returns over a 12-month period, others on a rolling five-year basis.

Some set themselves specific targets; others are more vague. So what, you might ask? The upshot is that investors are not comparing like with like when reviewing their choices.

The AR market in Ireland is tiny in comparison with the UK, but even the small Irish pool illustrates the potential for confusion.

Take one of the biggest players – Standard Life’s Global Absolute Return (Gars) Fund. At the end of June, this fund was invested across more than 10 asset classes, and employed almost 30 different investment strategies with such exotic names as the “European swaption steepener” and “US forward start duration”.

“For all but the most experienced person, to actually understand what the fund is doing or how exactly the decisions come about is probably expecting too much,” says Gary Connolly of Dublin investment consultancy firm I-Cubed.

Then there are Friends First’s two AR offerings: the Insight Currency Fund and the Market Neutral Equity Fund. The currency fund aims to profit from movements in exchange rates and is described in the sales blurb as a “portfolio diversifier” because it has “tended to have its periods of positive and negative performance at different times to certain other investments”.

The equity fund, on the other hand, takes both long stock market positions (ie, betting that the price of a particular share will rise) as well as short positions (ie, betting that the price of a share will fall).

Then there’s the BNY Mellon Real Return Fund, which uses a multi-asset approach, investing in anything from shares and bonds to forestry and emerging markets. Aviva’s offering is completely different again, with its Blackrock European Absolute Return fund investing largely in European shares.

These funds have very little in common, yet all of them are lumped together under the AR umbrella,which creates the potential for misplaced expectations.

“In the absolute return space, there is a comparison going on between various funds and I think some of the comparisons are inappropriate,” says Connolly.

Their performances also vary widely. Standard Life’s Gars fund grew just 1.6 per cent in the year to the end of June 2011, although in the previous year it delivered a return of 18.7 per cent. Friends First’s Insight currency fund has been struggling lately, and fell 6.5 per cent in the year to the end of June.

Fitch’s warning followed reports earlier in the year that the UK’s Financial Services Authority (FSA) was investigating the sales of AR funds.

The FSA wrote to a number of financial advisers and according to reports, their chief concern related to how funds were being described to clients, and whether advisers really understood these funds or were just recommending the latest fad.

There were reports too that the FSA has quietly advised firms launching new funds against using the “absolute return” label. It seems the worry is that the name creates the impression that growth is guaranteed. This danger was also highlighted by Fitch, which said the AR aim of consistently achieving positive returns may prove misleading if it is not clearly stated that returns are not guaranteed.

“Investors may be disappointed by AR products if they lack understanding and acceptance of their risk/return characteristics,” Fitch said. The agency also said that since the collapse of Lehman Brothers, AR funds have been far more focused on managing risks, and this focus may result in “modest returns”.

Then there is the sticky issue of fees. European AR funds tend to charge hedge fund-like fees, so that tends to mean a management fee of 1 per cent to 1.5 per cent, and a whopping 20 per cent performance fee. It should be pointed out that some AR providers in the Irish market do not apply performance fees, while others charge lower than average management fees, but it’s important that investors familiarise themselves with the charging structure before they hand over their cash.

Independent financial adviser Vincent Digby of Impartial.ie believes that as an alternative approach to investing money, AR “certainly has merit”. He explains that with traditional “long only” funds, the investor’s leap of faith is that the assets in which the manager invests will rise over time. With AR funds, the leap of faith is that the investor is picking the right fund manager.

Gary Connolly advises that the funds should be used in a diversified portfolio, but he has heard anecdotal instances of people investing as much as 60 to 70 per cent of their wealth in AR funds.

“If that’s the case, I think the sector is in danger of becoming a victim of its own success,” he says.

“Having gone through a decade with two savage bear markets, it’s totally understandable that people are searching for some new strategy that’s going to avoid the downsides. It’s the holy grail of less risk and more return – it sounds wonderful,” he says.

However investors need to cut through the marketing spin to make sure there’s “investment substance” backing it up. “And you won’t find that out by just looking at the label on these funds.”

Few small individual investors have the time, knowledge or inclination to acquire a thorough understanding of exactly how these funds operate. Therefore advice is key, Connolly says.

However this recommendation is based on the assumption that financial advisers have a solid grasp of exactly how the different AR funds operate, and that in itself requires another leap of faith.

Investors may be disappointed by AR products if they lack understanding and acceptance of their risk/return characteristics