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ABSOLUTE RETURNS: What’s in a name?

Question-markThe growing range of absolute return funds has been called a confusing jumble of strategies that risks misleading less savvy investors. George Mitton asks if regulators should move to discourage the term.

According to the ratings agency Standard & Poor’s (S&P), “there is still some confusion among investors, particularly in the UK, about the definition of absolute return funds and what they can be expected to achieve”.

Fitch Ratings, meanwhile, is worried. “The lack of a commonly agreed definition and clear categorisation by strategy within the sector poses an increased risk of mis-selling to less sophisticated investors,” it says.

These doubts come as the number of absolute return funds on the market increases. Last year, sales were up 60% compared with 2009, according to data firm Lipper, and in March there was €140bn under management by Europe’s absolute return funds.

As these contentious products rise in popularity, is it time regulators moved to dispel the confusion?

The main problem with absolute return funds is that they are defined not by what they invest in but what they aim to do, which is to generate returns in excess of cash.

On one hand, this gives the flexibility to tactically manage asset allocation and pursue strategies that should, in theory, be able to make money in all market conditions. But it also means the products are free to invest in anything. Absolute return is merely the label on the box; it is up to the asset manager to decide what goes inside.

This inconsistency is perceived to add muddiness to the industry, making it hard to compare similarly named funds and putting less savvy investors at risk of buying inappropriate products.

However, the response from regulators has so far been muted. A spokesman at the Financial Services Authority (FSA) said that although the authority would investigate specific cases of mis-selling, it “has no special eye” on absolute return as a fund type.

The Investment Management Association (IMA), meanwhile, has concluded in two previous reviews that the name absolute return and the IMA’s definition of the term are fine. A spokeswoman said the association will reconsider in its next review whether the term is “a good turn of phrase” to describe these funds, however.

Is absolute return a problem? The term certainly provokes strong feelings. Patrick Rudden, head of blend strategies at AllianceBernstein, says absolute return is “one of the more insidious names” in the investment industry. Insidious because the name suggests a guaranteed return when in fact these funds promise no such thing.

“Most of the strategies depend on a manager having skill and that skill being rewarded; there’s nothing absolute about either of those,” he says.

Indeed, a look at the funds in the IMA’s absolute return sector reveals that a number of products actually lost money in the twelve months ending 30 June (see box, below). If investors chose these funds to preserve their capital, they were bitterly disappointed.

A larger proportion failed to beat inflation. According to investment data firm FE Analytics, only 43% of the funds in the IMA’s absolute return sector beat inflation in the twelve months. This means more than half the funds ended the year with a net asset value that was worth less, in real terms, than at the start of the year, and that’s discounting fees.

Given this uneven performance, should regulators do more to force transparency from the industry about what these funds do and do not promise?

According to Merrick Styles, head of Amundi’s absolute return business in the UK, the name is accurate, but there is a need to explain these funds better. “I think absolute return is the right term, I think there needs to be a lot more education, a lot more consistency in the way it’s sold, because there is this misunderstanding,” he says.

The part of Amundi’s UK website that is dedicated to publicising its absolute return range says: “Absolute return management aims to deliver positive returns irrespective of underlying market trends.”

The desire to generate positive returns relative to cash is not new; hedge funds have targeted this ever since they were developed in the late 1940s. But managers like Matt Eagan, who runs an absolute return product for Loomis Sayles, believes these funds are different.

“This is an in-between category,” he says. “It’s not a hedge fund but it gets you closer towards a hedge fund mentality.”

Like hedge funds, absolute return products often use short selling to make money when assets go down in value. They generally achieve this via derivatives so as to comply with Ucits rules. Absolute return products are often multi-asset funds where managers can shift their exposures at will, just like hedge funds.

But Chris Wyllie, director of Iveagh Private Wealth, believes the distinction is less clear. He argues that most of these products are simply “hedge fund strategies in regulated format”.

They occupy the same space in his clients’ portfolios as hedge funds and are used as risk diversifiers. But if they are essentially hedge funds, why the need for the different name? “It’s perceived that the term hedge fund scares people off,” he says.

Safety zone?
The term absolute return, therefore, is essentially a marketing concept intended to make these funds sound safer and appeal to a wider audience. However, their recent success owes as much to the financial crisis as it does marketing.

“It’s no coincidence that in the years following a bone-crunching bear market there’s suddenly a lot of products promising an absolute return, because it was absolute return that would have saved your bacon in 2008,” he says.

For critics of absolute return, the term has more than a whiff of false advertising. Would these products be as seductive if they were called regulated hedge funds? Perhaps not.

However, there are many within the industry who deny this is a problem. Firms dealing principally with institutional investors are particularly dismissive; they say their clients are either sophisticated enough to understand the subtleties or have intermediaries to explain it for them.

“I don’t see a lot of evidence of our absolute return funds being simply sold off the page to end users,” says Dan Mannix, head of business development at RWC, which sells to institutions and private banks, often via professional intermediaries.

“This concept of mis-selling,” he adds, “who is doing the mis-selling? I don’t see much evidence of the fund management industry itself running that risk."

Terry Mellish, head of UK/Ireland business and global and UK consultant relations for Natixis Global Associates, also points to the role of intermediaries. “Everybody works very hard to ensure their clients aren’t confused by solutions or products,” he says.

According to this view, the problem of confusion, if it occurs at all, is limited to the retail market. Most fund managers accept that mis-selling to these customers is possible, but believe the problem can be solved by encouraging people to read the small print on their funds.

The general view from the industry is that companies would rather spend money on educating clients about absolute return than stop using the name, because this would mean losing an effective branding tool. It seems that if there is to be reform, it must be imposed from outside. Is this likely?

Time to intervene
Recent comments from the FSA suggest a greater willingness to intervene on fund marketing. Last year, Peter Smith, head of investments policy in the FSA’s conduct policy division, said: “Where in the past we might have concentrated on sales practices to try to ensure good outcomes for consumers, we will now intervene earlier, in product design and the marketing by providers of those products to distribution firms.”

In this context, it is disappointing that the FSA has nothing to say about absolute return. However, there may be movement underneath the radar. Anecdotal evidence suggests the FSA has asked some investment companies to avoid or drop the term absolute return. Whether this will crystallise into an official policy remains to be seen.

Elsewhere, the IMA may recommend changing or dropping the name after its next review. However, the association admits it is currently preoccupied by a debate about its controversial new sector names.

In the meantime, sales look likely to grow, but industry observers continue to have doubts about the fund class. S&P has yet to award an absolute return fund a triple-A rating, even those that have achieved their targets in every calendar year.

Meanwhile, Fitch Ratings is concerned that the lack of clear definitions may lead to “style drift”, where managers meander away from the investment principles established at the outset of their funds. The agency is also worried that the lagging performance of some funds relative to higher risk strategies “may encourage higher risk taking from absolute return managers”.

It seems controversy over these funds will endure and, while uncertainty in the markets continues to make investors nervous, so will their popularity. The problem of absolute return is nowhere near solved.

©2011 funds europe