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Capital ideas as rates fall

By Nicholas Watts

For most investors, the name of the game at present could be summed up as ‘capital preservation’ rather than hoping for double digit growth.

The problem is, of course, dependent on the investor’s time horizon.

But, ignoring this for the moment, if you currently ask anyone how they might feel about their portfolio falling 25% overnight the answer will be a resounding “No thank you.” So, are there any solutions?

Cash might be low volatility, but rates are poor at present and do not cover inflation.

In order to gain you have to take some risk and, that being the case, the question is can it be reduced in some way by the investment vehicle into which you have put your money?

There is a growing sector in the market called ‘Absolute Return,’ which seeks to do just this, so let’s look “under the bonnet,” as it were, and see how they operate.

As I have said, the aim of an Absolute Return Fund is to generate positive returns in excess of cash on a consistent basis and to try and preserve capital in a falling market.

The more perspicacious amongst you may immediately say that this is what a hedge fund aims to do.

And you are right to some extent, but with some major differences. A key factor is the way in which they each came into the market.

Hedge funds have been the preserve, mostly, of institutional funds.

Then in 2000 the Undertakings for the Collective Investment of Transferable Securities regulations allowed retail funds — that is, the sort of funds the general public use in Individual Savings Accounts, pensions and life assurance bonds — to employ the investment techniques and instruments that have long been used by hedge funds.

These include short selling, long/short investing, leverage, derivatives, diversification and the use of exotic securities.

There is however one difference. Absolute Return Funds “hedge” in order to try and remove market risk, for example by market neutral positioning.

This will prompt you to ask why hedge funds have not done the job that the investing public expects. One of the reasons has been that, unlike Absolute Return Funds, which are very liquid, many of the hedge funds are not.

This, coupled with a run on them, has left their overall performance looking very poor. By contrast, the best Absolute Return Funds have produced returns of 7% in 2008.

However, do not be fooled by funds that are merely conventional.

The important point here is that, unlike the standard equity-based funds, Absolute Return Funds are more complex and difficult to understand and it is not a question of simply good stock picking.

Here’s an example of the sort of trade they might employ:

If a fund manager believes that a certain stock will rise in value, outperforming its peers in the sector, he will invest in that stock and at the same time he will invest in an instrument that will generate a profit if the sector as a whole falls in value.

This enables the fund to generate profits irrespective of how the bet went.

Sounds simple. But there is one important point that you need to take into account. In a bull market such funds will not capture all the upside performance.

So, if you are looking at your portfolio, you may find Absolute Return Funds useful as a capital preserver.

Nicholas Watts is an independent financial adviser with Positive Solutions Financial Services which is regulated by the Financial Services Authority. To contact him, use the website

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