Simply Money Spring 2009
At a time when investment markets have been falling, the words ‘absolute’ and ‘return’ could well seem attractive. But this area requires careful consideration … and professional advice.
With investment markets displaying many of the characteristics of a roller coaster ride, investors could be forgiven for seeking ‘safer’ alternatives to investment markets. But these are not always what they seem and the so-called absolute return funds may not offer all that might be expected.
Absolute return funds aim to give a positive return to investors even on a falling market, doing so through a variety of strategies including the use of bonds, property, cash and so-called ‘hedge’ funds. They also frequently use what are called derivatives—investment instruments that are ‘derived’ from other markets, such as equities by allowing investors to ‘bet’ on future market movements. The principle is that you can make money on a falling market provided that you can borrow shares and sell them at the current price, buying them back when prices have fallen (then returning them to the original owner), so that you make a profit on the difference.
There are considerable risks inherent within this strategy, not least that you get your bets wrong and have to buy back the shares at a higher price in order to fulfil your contractual obligations.
The actual strategy adopted varies from fund to fund, but the aim is always to give a positive return, whatever happens to markets. In practice this is not always achieved and, in a rising market, these funds almost always underperform more conventional funds. And it is here that the crux lies.
Compared with what, if not the market?
Most investment managers compare their performance with the sector in which each fund is invested. So if the managers can achieve a ‘top quarter’ performance for their fund within the appropriate equity market, they feel they are doing well.
The problem is that, in a falling market, this might simply mean losing less money than most competitors. But individual investors are more interested in seeing their money grow in monetary terms, rather than just comparatively; this is where the apparent appeal of absolute return funds lies.
However, there is little evidence to date that those funds using derivatives actually do much better than more conventional investments. For example, in the last quarter of 2008, the average hedge fund lost 10.23% of its value (source: www.Morningstar.co.uk) while the FTSE100 lost just 9.55% (although the Dow Jones lost a hefty 19.12% over the same period)
What goes down usually comes back up again
For some investors, absolute return funds may have a place in their portfolio. However, most investors may feel that the long term performance of investments are such that recent losses are likely to be reversed within conventional funds, so that making a switch now might be the wrong decision.
There are no guarantees in investment markets, but recent developments simply reinforce the adage that equity investments should always be seen over the longer term, ideally at least five years.
- Some funds aim for positive returns in any market
- There is no such thing as a ‘risk free’ investment
- Advice is essential to understanding the risks Importance of advice