Absolute return funds suffer "absolute washout" in 2006, says S&P

Absolute return funds, retail investment vehicles that take advantage of the European Ucits III funds legislation to use derivatives and other hedge fund-like techniques, suffered an 'absolute washout' last year, according to Standard & Poor's Funds Services, with none of the funds it surveys meeting their own investment objectives.

Absolute return funds use cash as their benchmark and aim to outperform standard measures such as Libor by at least 100 basis points before fees, whatever the market conditions. But last year all the funds included in S&P's absolute return sector fell short of their return targets after fees, and most failed to match the performance of cash.

Most of the under-performance was due to a difficult year in fixed-income investment, according to Standard & Poor's lead analyst Kate Hollis. Many funds had incorrect duration positioning at some point, she says, whether from quantitatively-driven models as at Robeco Flex-O-Rente, or from fundamental decisions as at JP Morgan RV4.

'A number of funds also had reasonably high exposures to emerging market debt and these were caught by the emerging debt wobble in the second quarter of 2006,' says Hollis, noting that risk management processes had prevented several managers from responding effectively to the market wobble.

Aside from fixed income, there were difficulties for fundamentals-driven multi-asset funds from the wide increase in risk aversion affecting asset classes such as emerging debt, emerging equities and commodities. The Pioneer Investments Total Return and Fortis Absolute Return ranges were both badly hit and had their first disappointing years.

The impact of poor performance is evident from S&P's assignment of ratings following its review of 21 absolute return funds over the 12 months to March 1 this year. There were no AAA ratings and only one AA rating, for the Mellon Evolution Global Alpha fund.

S&P notes that this fund is very different from the other absolute return funds it rates, using a quantitatively driven, tactical asset allocation process that invests only in highly liquid bond futures, equity indices and currencies. S&P assigned 15 A ratings to absolute return funds; one fund has been downgraded to Not Rated, and four funds are currently under review following recent changes in their management teams.

However, Hollis says a few absolute return funds are now on course to achieve their targets by the end of this year and most are now outperforming cash, although a couple are showing losses after fees and a couple were flat at the end of March. 'Standard & Poor's absolute return process compares funds to their own objectives,' she says. 'By definition, we only rate funds that we believe have the potential to achieve their return and risk targets consistently.'

Standard & Poor's Fund Services provides fund management ratings on more than 2,200 funds worldwide. Unlike past performance rankings, these ratings are based on analysis of the stability of a fund's parent group, the appropriateness of its investment policy, and the sustainability of its performance.

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