Avoid Irish ‘Funds of Absolute Return Funds’
The new investment product on the block appears to be ‘Funds of Absolute Return Funds’. The name is a hell of a mouth full and, unfortunately, they are as complicated as they sound. After an extremely trying and painful decade for both equity and property investing, the Irish insurance companies are desperate to sell an investment product that has proven to be more resilient. The point of this article is to explain why ‘funds of absolute return funds’ in the form of unit-linked funds are almost certain to disappoint investors. As I understand it, absolute return funds are a sub-category of hedge funds.
A hedge fund exists to try and generate a positive (absolute) return each year for investors over and above cash deposit returns i.e. they are trying to both protect capital and deliver a better than cash deposit return. They use the markets to do that and, with the flexibility to sell stocks, bonds and a range of other financial instruments short (i.e. to sell what they do not own in an effort to buy it back lower at a price), they can take advantage of declining as well as rising markets.
The attraction of hedge funds is that they facilitate further risk-asset diversification. For example, if equity markets decline then equity funds will deliver a negative return. Over the same period, however, a hedge fund might deliver the promised positive or absolute return, in which case the negative return from equities will have been partly or wholly offset by the positive returns from the hedge fund.
In a decade where equities and property returns have failed investors and where the risks still look considerable, who wouldn't settle for an annual return over and above cash deposit rates? The difficulty is in delivering it. As hedge funds don't own assets, but trade assets, they have to scalp other investors in a zero sum game. The risk is high that a hedge fund manager loses the poker game and obtains a negative return. And without an asset to show for it, the loss is a permanent one. So no matter what you hear to the contrary, many hedge funds can, and do, disappoint.
And this is where 'Funds of Hedge Funds' comes into it. To guard against the real possibility of negative returns from any single hedge fund - why not pool several hedge funds into the one fund to spread the risk. But what appears to be a good product idea in theory becomes unwieldy in practice.
The accepted targeted annual return within the hedge fund industry is in the order 7-8% per annum after fund management fees. This is a demanding target when you consider that they are trading assets, as opposed to owning them. Over the long term the owners of equities have obtained an annual return of circa 10% per annum before costs. To trade assets, which is far riskier over the medium term, and obtain an annual return of 7-8% after 2% annual management fees, which is the hedge fund norm, suggests to me that the promoted 7-8% annual return target is beyond reach.
Nonetheless, giving the hedge fund industry the benefit of the doubt, let’s accept the 7-8% annual target return as realistic. Compared to short term interest rates of 1-2% and long term interest rates at 3-4% across the developed world at present, a 7-8% annual return does indeed look enticing.
But the retail investor has no chance of obtaining these returns through the unit-linked funds structure on offer via the insurance companies and banks in Ireland. First, we must factor in the marketing, distribution and trailer fees involved in selling unit-linked funds of circa 1.0-1.5% per annum at a minimum (in many cases a good deal more), which lowers the likely return to 6.0-6.5%. We must then factor in a further 1% per annum cost for the ‘fund of hedge funds’ structure. The retail investor is now staring at a maximum medium term return of 5.0-5.5% per annum, and this from a risk asset.
Pretty soon, those cash deposits, which carry no costs or risk of loss, begin to look somewhat more attractive. Taking a medium term view, short term interest rates are likely to rise and investors who wish to avoid the volatility associated with equity products must ask themselves if they would not be better off with a bit of patience.
The only realistic way for investors to get the returns available from hedge funds is to invest directly in them by cutting out the seller. To do this, investors must buy 'Funds of Hedge Funds' that are listed on the stockmarkets in the form of either exchange traded funds (ETFs) or investment companies. But as financial advisors earn when they sell a unit-linked fund, the customer has no chance of being offered the more cost-effective solutions.
In 1999, I well remember the aggressive advertisements pushing 'tech funds' on the retail investor in Ireland. The funds in question caught the top of the technology bubble perfectly and killed the retail investor in the process. Role forward to the property bull market and by late 2006 geared property funds were all the rage. Well meaning as they may be, the insurance companies and banks are not there to help the investor but to help themselves.
Rory Gillen
Founder
www.investRcentre.com