Absolute return funds: too good to be true?

When the financial services industry comes up with a great new story, watch your wallet. Absolute-return funds (ARFs) are a classic case in point. The idea is sound, but investors who bought the story have been mostly disappointed.

The story is simple: rather than try and beat their peers as many conventional funds claim to do, ARFs typically promise to maintain a positive (absolute) return in all market conditions. So they might offer you the money market cash rate plus x%', for example. As such, they are often marketed as being lower risk than other funds the idea is you'll make a steady, if unspectacular, return regardless of market conditions.

The appeal is obvious in volatile markets when most investors want to protect their capital as much as make big returns from it. So it's a pity so few funds are delivering.

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According to consultancy Informed Choice, which recently carried out a study of 51 funds looking at performance, consistency and charges, only three are currrently worth investing in. Two-thirds of the funds reviewed managed to score fewer than half of the maximum points available on the three key criteria combined. What's going wrong?

The main problem is an old Money Week bugbear charges. Alan Miller at wealth manager SCM Private has carried out a review of 28 ARFs andconcludes on FTadviser.com that, on average, 38% of gains over a three-year period were eaten up in fees. Another problem is that some ARFs have to rely heavily on derivatives and the ability to run short positions (bet on prices falling). This can make returns pretty unpredictable, the exact opposite of what the sector promises.

A linked problem for investors is a lack of liquidity. The more complicated the strategy chosen by an ARF, the less likely it is investors can trade easily in or out of the fund. No wonder the regulator, the Financial Services Authority, has announced it will be carrying out a review of the whole sector this autumn.

So what to do? The truth is many investors could often do better than an expensive ARF with a cheaper combination of a cash deposit and a simple index-tracking exchange-traded fund. If you still want to buy into an ARF, the fund that scored highest in Informed Choices' study was the Henderson Credit Alpha fund (telephone contact: 0800-832 832).