Absolute return funds: too good to be true?

With China's "Black Monday" generating stockmarket mayhem around the world, you might be feeling a little nervous. It can be tempting to pull your savings out of all markets entirely and sit in cash. But while we'd always suggest having part of your portfolio in cash (it's always good to have some powder dry and cash also has characteristics that make it a useful portfolio diversifier), making big decisions in reaction to sharp moves is often something investors live to regret.

Wouldn't it be better if you could have a fund that would put a cautious investor's mind at ease by holding a nice mix of defensive assets and aiming to protect you from the worst of a downturn? That's an attractive sales pitch, and the financial industry knows it. Hence the rise of the "absolute-return" fund. The basic point of these funds is to ignore what the stockmarket is doing, and simply aim to achieve a positive "real" (after-inflation) return each year.

It sounds sensible and the sort of thing that a cautious investor or one still rattled by the events of 2008 would find very appealing, which is why so many launched in 2009 and 2010. Trouble is, they've failed to deliver.

According to recent research by FE Trustnet, only a quarter of absolute-return funds have consistently delivered positive returns over the past five years, despite the sector generating record sales this year attracting £579m in April alone and £1.2bn this year. Only eight of the 39 funds with a five-year track record lived up to their names, notes Kyle Caldwell in The Daily Telegraph, including the Insight Absolute Equity Market Neutral and Insight Absolute Insight funds.

The sector in general has been criticised for giving investors a false sense of security, but other problems include managers lacking the expertise to short-sell successfully, and the fact that many of the funds are still highly correlated to equity markets.

However, Caldwell does suggest two good alternatives. The Ruffer Total Return Fund has delivered a positive return every year since 2007, including a 21% return during the 2008 financial crisis. It invests in gold, cash and inflation-linked bonds, with the latter making up 40% of its assets. Another MoneyWeek favourite is Personal Assets Trust (LSE: PNL), which invests in gold bullion as well as international equities. It has strong downside protection, notes Leonora Walters in the Investors Chronicle the trust's share price only dipped by 3.2% in 2008, compared to the average of 30% for most global growth investment trusts.