Absolute return funds could be turning into Europe's next investment mis-selling row. As freefalling equity and bond markets ravage people's savings, private investors globally are piling into the funds, which aim to deliver positive returns whether markets are rising or falling. That demand has driven the assets held in absolute return funds to 182.1 billion euros globally at June 30, data from Lipper, a Thomson Reuters unit, show.
This is almost a fifth higher than a year ago and double the assets held in such funds at the start of 2009. Perhaps encouraged by such headlines as "Absolute-return funds - a safe haven?" from one UK newspaper in 2008, people may think these investments can't lose money. They absolutely can.
The funds may seem simple and safe, but they are more like the sophisticated hedge funds beloved of wealthy speculators than traditional mutual investments. Britain's Financial Services Authority fears people may be buying them because they misunderstand the funds' objectives, believing labels like 'real return' or 'absolute' mean their initial investments are either protected or guaranteed to grow.
"The danger with that of course is that is not what they are selling at all," says Bruce Moss, founder of UK-based Advisa Centa, which develops risk management tools for financial advisers. "They are selling an investment strategy that may or may not be successful over a period of time, which again is not defined." It's not just 'mom and pop' investors who are at risk.
Swiss watchmaker Swatch Group is seeking damages of around $30 million from UBS after an investment it made in an absolute return fund failed to meet expectations. A source familiar with the details of the case, who requested anonymity in respect of the legal process, said Swatch is arguing it invested in the product because it was assured the capital it invested was safe, and was guaranteed against downside risk.
A spokeswoman for UBS said the bank had given the court a statement of defence of its product and marketing materials but declined to elaborate, in line with company policy on commenting on live lawsuits. Swatch CEO Nick Hayek declined to comment pending resolution of the case.
The funds have been on the radar of the FSA for several months, as pension investors spooked by volatile stock markets have stepped up efforts to lock in some kind of return. It warned in March that consumers, and their investment advisers, could find it difficult to assess how much risk they are exposed to in the funds as the strategies used by managers become more and more complex.
So what does 'absolute return' mean? 'Absolute' may seem like a synonym of 'total' or 'guaranteed', but it is nothing of the kind: it has more arcane roots, to do with the way performance is measured. Most funds compare how their portfolios have done with a benchmark of some kind, such as an index.
Originally, 'absolute' funds were so called because they set out to be measured by their own targets, not relative to something else. In a falling market, the best most funds can offer is that their investors may lose a bit less than others: absolute return funds aim to make money anyway. There are other differences. Most investment funds are defined according to the assets they are permitted to buy, such as shares, bonds, or commodities, but absolute return funds can put cash in whatever motley mix they think will help them turn a profit.
Their popularity has brought together uncomfortable bedfellows: jittery retirement savers or college-fund builders, who above all want to keep their money safe, and fund managers who are often forced to use risky derivatives or hedging tools. Critics say that union is unnatural and fraught with potential problems, particularly when it comes to communication.
"Many mis-selling problems arise from the failure to effectively communicate likely outcomes and the risks involved to the end investor," says Moss. "There is a real danger that this could occur with absolute return funds." Importantly, too, the funds are not designed to capture all the upside of rising markets. Their emphasis is on liquidity - being able to buy or sell when needed - and offering protection against falling prices. Their performance may be tame, but - even though some names include terms like "cautious" that emphasise a sense of safety - it is not risk-free.
In an environment where the standard recourse of the cautious investor, such as a money-market fund, delivers below-inflation returns, that's a point both investor and adviser may be tempted to overlook. All of this boosts the potential backlash if investments turn sour.
Britain has recently experienced significant mis-selling scandals, and the financial services industry's compensation costs are already high. Fund managers faced a bill of more than 230 million pounds ($377 million) in 2009 after the collapse of a life-settlement business called Keydata, whose complex products lost thousands of UK pensioners hundreds of millions of pounds despite having been marketed as low-risk.
UK banks have been forced to take billions of pounds in charges related to mis-selling payment protection insurance policies which many customers bought without knowing. Given the size of the absolute return business, the costs associated with any mis-selling claims could be huge.
What may first make the funds vulnerable to mis-selling claims is their erratic performance. According to data provider FE Analytics, fewer than half the 69 funds in Britain's Investment Management Association's absolute return sector - one of several categories the UK trade body uses - beat inflation in the 12 months to the end of June.
Eleven even lost money over the year. Standard Life Investments (SLI) is one of Europe's largest absolute return fund managers with more than 11 billion pounds under management in the strategies.
Its investment specialist Tam McVie says the products do offer opportunities for solid risk-adjusted returns without the volatility of equity market investments: its 8-billion pound Global Absolute Return Strategies Fund, which at end-June had bets on assets as diverse as Mexican interest rates and Russian stocks, has delivered 8.6 percent annually since 2008, he said. Its volatility at 6 percent has been a third of the level seen in equity markets. But McVie also recognises that the typical absolute return fund is becoming more complex, so demands extra scrutiny from potential investors and distributors.
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