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4.2.3 Absolute returns

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Figure 7 Investors have an array of fund managers to choose from.

The relative approach to peer groups or to benchmarks does not always work well.

In the dot-com crash of 2000, for example, when pension funds suffered badly as the equity market fell, pension fund managers argued that they had all lost money, so it didn’t really matter. This included even those who outperformed the benchmark (which in this case means that they lost less than the benchmark), but this was a matter of concern to company directors, who found that their company pension funds had to be topped up to cover the stock market losses. They decided to turn to fund managers who promised absolute returns, that is (hopefully), positive returns whatever the economic situation.

So, for example, the fund might promise not to outperform the FTSE All Share Index by 2% – a 10% fall in the index would still mean a loss of 8% – but rather to earn, say, 4% more than the risk-free rate. Two types of investment that promise absolute returns are some types of hedge fund and structured products.

Absolute return hedge funds

A hedge fund is a fund that is allowed to use aggressive investment strategies through high leverage (borrowing). This is different to the position of unit trusts and OEICs (who can only borrow to a very limited extent) and investment trusts (whose leverage is normally capped). Hedge funds are exempt from many of the rules and regulations governing unit trusts and investment trusts, which allows them to invest large amounts at any one time. Retail investors can invest in so-called ‘funds of funds’ that are unit trusts or OEICs investing in a number of hedge funds with varying investment strategies. As with traditional funds, investors in hedge funds pay a management fee, however, hedge funds also collect a percentage of the profits (usually 20%).

Unlike the managers of unit trusts and investment trusts, hedge fund managers can sell shares short. So, for example, managers of a ‘long/short’ hedge fund will buy shares that they like and sell those that they don’t, in equal amounts, so netting out the market exposure and keeping specific risk relatively low. In such a case, the risk of the hedge fund will be uncorrelated with market risk and will offer pension funds, and other investors seeking to diversify away from equities and bonds, a positive expected return. However, in practice, such hedge funds use a lot of leverage to enhance expected returns and many suffered from the lack of liquidity during the credit crunch and were forced to sell shares into a falling stock market. Their returns turned out to be more positively correlated with market returns than investors had anticipated.

Structured products

A typical capital structured product is one that will offer, as a minimum, return of the original capital invested at the end of a period of three years, for example, and any upside of, say, the FTSE 100 stock index. This would mean that if, at the end of three years, the FTSE 100 was lower than the index value at inception, customers would receive £100 per £100 invested. If, on the other hand, the FTSE 100 had risen by 20% by the end of the three-year period, the investor would receive £120 per £100 invested.

Guaranteed products are typically put together by investment banks or other investment institutions by using combinations of bonds, shares and derivatives. As a result, guaranteed products are called structured products. Structured products are exposed to the counterparty risk (see Week 3) of whichever banks or other institutions supply the underlying guarantees. Counterparty risk was not considered to be significant until 2008, when Lehman defaulted on a number of guarantees underpinning structured products, although some of these guaranteed products have since been honoured by the banks that had marketed them.

It is worth pausing to ask how the client is paying for having the best of two worlds – limited downside risk and yet upside potential. The answer in the case of capital-guaranteed products is in foregone income. For the whole of the three-year period, no interest is paid and the rise in the index excludes dividend income. Depending on the size of the dividend foregone, this can be equivalent to quite a high annual charge.