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Are absolute return funds an absolute waste of time for investors?

Ones that promise to shelter investors from volatile markets can charge high fees

Absolute return funds have exploded in popularity over the past two years as retail investors have flocked to invest, drawn by their promise to provide returns in all market conditions.

However, investment analysts covering the sector are concerned the funds are difficult to understand, promise the impossible and charge high fees.

The funds performance has also been less than stellar of late. According to data from Morningstar, two-thirds of UK-domiciled absolute return funds have posted negative returns in 2016, despite being on course to register a record year of net inflows.

All of this has attracted the attention of regulator the Financial Conduct Authority, whichtold the Financial Times last monththat it would scrutinise absolute return funds as part of its wide-ranging review of the asset management industry.

Here are the questions to ask if you are considering putting your cash into an absolute return fund:

Funds that fall into the absolute return category follow a very wide range of strategies, but they generally look to keep volatility low and deliver returns in all market conditions.

According to analysts at Morningstar, the funds can be broadly described as having hedge fund-like strategies but with a few key differences. Like hedge funds, absolute return funds tend to take short positions and use derivatives to achieve returns. However, because they operate according to rules governing retail funds, they are not allowed to hold certain illiquid assets and they do not borrow money to make their trades.

Beyond these general similarities there are lots of different fund management strategies that all fall under the umbrella of absolute return, from relatively straightforward equity funds holding both long and short positions, right up to multi-strategy funds that run tens of different mini-strategies within them.

So whats the problem and why is the regulator concerned?

It is not clear at this point why the FCA is investigating, or exactly how concerned it is. It has said that it will look at the sector as part of its wider review of the asset management industry this year, but has so far declined to provide any more detail.

Fund analysts, however, are worried that the funds promise too much. I think its unrealistic to expect any fund to perform all of the time no matter what it does, said Adrian Lowcock, managing director of Architas, a fund selection company. Its not realistic to have a higher than cash return without the volatility its having your cake and eating it.

Michelle McGrade, chief investment officer of TD Direct Investing, said investors had to take a gamble on whether absolute return funds would do what they claimed. In this environment youd like your absolute return funds to be doing as they say some of them are and some of them arent, she said. There are very few that are.

There are also concerns over whether investors really understand what they are buying. Hargreaves Lansdown, the UKs biggest retail broker, stopped recommending Standard LifesGlobal Absolute Return Strategiesfund to its customers some years ago. Mark Dampier, senior analyst at the company, said the funds strategy had become so complicated that he did not feel comfortable recommending it to investors. We dont buy it because we cant analyse it, he said.

Mr Dampier said investors needed to look hard at any fund in the sector to make sure they understood it. Youve got a cocktail of different types of fund, and youve really got to get under the skin of them to understand whats going on, said Mr Dampier. At least if you buy an equity income fund, you know what youre getting.

But if you know what youre getting into, are these funds a good buy?

Yes and no. Its like any other sector most of the funds arent that good, said Mr Dampier.

Performance across the sector has been poor this year, but Mr Lowcock of Architas says some of the funds did a good job at protecting capital during the financial crisis, and are worth investing in as part of a larger portfolio.

TD Direct Investing recommends Newton Real Return to its investors, while Hargreaves has chosen Newton, alongside Pyrford Global Total Return. Meanwhile, Fidelity Internationals investing team have put Hendersons UK Absolute Return on their select list.

However, bear in mind that these funds can be expensive to buy. Unlike most other retail fund sectors, absolute return funds tend to haveperformance feesand charge investors if the fund returns more than a set benchmark.

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