Absolute Return Funds? That's about the long and short of it....

There is a lot of focus at the moment on Absolute Return funds, especially amongst people who rely on their savings to produce an income and have been through denial, past disbelief and are stood at the fork in the road between depression and selling a kidney.

In a sentence, an Absolute Return fund is one that aims to generate a positive return, whatever the market conditions. So what kind of sorcerer’s magic is used to create such results? In the words of the great L'Oréal, ‘here’s the science bit’

Traditional investment funds aim to generate their growth in the long term by benefiting from a rise in the markets. This is known as going long. Shares are bought when they are low, held for a while and then sold at a profit when they have increased in price. The disadvantage being that growth is only produced when the markets rise, and a loss is made if the markets fall.

To understand ‘true’ Absolute Return funds we also need to understand short selling, which has a bit of a pantomime villain image. This is completely unwarranted and you can no more blame a company’s failure on short selling, than you can blame the passengers on a bus for it being driven over a cliff.

Shorting is a way of betting that a certain share price will go down in value, and making a profit if it does. Imagine your next-door neighbour goes on a three-month cruise and leaves his house keys with you so that you can water his tomato plants. Whilst he is away you sell his house for the market value of £100,000 and pocket the cash. Over the next three months the housing market goes down and you then buy it back the day before he returns for £90,000, before returning his keys and dead tomato plants. You’ve just made £10,000 profit by shorting.

Some of the sharper readers may have noticed the potential flaw in the process. If prices go up, then you have to buy it back for more than you sold it for, which is not a good place to be.

So, the secret is to go long and short at the same time. Say you think that Asdaco supermarket is going to announce good trading results and you go long on their shares in the knowledge they are likely to rise on the news. However, you also go short on the shares of their rival Morriburys, because their share price is likely to drop on the news of their competitor’s triumph. If you have predicted it correctly then you gain on your long, and also on your short.

If you get it half right, and the whole retail sector goes up or down, your position is protected because what you lose in your long positions, you should gain in your shorts and vice versa.

Naturally, if you get it all wrong and your long shares dive and your short shares rise then you’re going to look like a bit of a ninny, but that’s why investment fund managers drive Porsches.

By getting the selection right, a gain is made irrespective of market conditions hence the term absolute, or target fund. The fund will set out its targeted return, which could be anything from 5-15%, and it will aim for this return no matter what the markets do. Beware however, of funds that pretend to be absolute funds when in fact they are nothing more than a traditional long fund, with a bit of window dressing and snazzy marketing literature.