The absolute wrong way to invest in the stock market

by Ed Bowsher on 04 January 2012  |  1 comment
Tweet

Don't be tempted to put your money in an absolute return fund. They're an absolute rip-off.

The UK stock market has had a rotten time over the last twelve years. At the end of the 1999, the bellwether index closed at 6,930 points. As I write, it’s at 5,704 points, an 18% fall. That’s a very disappointing performance. 

So it’s no surprise that absolute return funds have become popular in recent years. These funds are supposed to be less volatile than conventional investment funds and should, in theory, go up in value every year. Or most years anyway. 

Fans of absolute return funds give two reasons to support this theory: 

-          Managers of absolute return funds can ‘go short’ if they wish. Conventional fund managers are restricted to buying shares in companies and hoping that their share prices will go up. Managers of absolute return funds can also make bets that a company’s share price will fall. 

So if stock markets are falling, absolute return funds can still make money. 

-          Absolute return funds supposedly attract the best managers. Until recently, the best investment minds worked for hedge funds and ordinary investors weren’t able to benefit from their skill.

But now that absolute return funds can be sold to individuals, all of us can join the party and see the value of our savings rise year-after-year regardless of what happens in the stock market. 

It’s a nice-sounding theory. Trouble is, what’s happened in practice tells a different story. 60% of absolute return funds lost money last year. The FTSE 100 index fell 7% last year, but one UK absolute return fund – the Polar Capital UK absolute return fund – fell by 13.9%. 

Even worse, the charges are shockingly high. The initial charge is 5% while the Total Expense Ratio is 2.49%. In other words, you’ll be paying an effective annual charge of 2.49% for the privilege of sticking your money in this fund. 

In fairness, the Polar Capital fund has delivered much better performance over longer periods but let’s remember that absolute return funds are supposed to deliver consistently good performance year-after-year. The Polar Capital fund has failed to do this. 

Yes, other absolute return funds performed better last year but 60% lost money when they’re supposed to go up every year. And most have charged high fees. They’ve failed in their objective and made a lot of money from investors in the process. 

Sure, you may get lucky and pick an absolute return fund that goes up every year for the next five years but it’s a hard trick to pull off. 

Alternatives 

So if I’ve put you off investing in an absolute return fund, is there anything you can do instead? 

The obvious alternative is to invest in the stock market via a tracker fund. These are cheap funds that enable you to benefit from rising share prices. Read more in Six great reasons to choose an index tracker. 

It’s true that your tracker will fall in value if share prices fall. And given the gloomy outlook for the global economy, there’s a good chance that shares won’t perform well over the next three or four years. 

But if you’re able to keep your money in shares for the next ten years, I think there’s a strong chance that you’ll do fine or better than that. Share prices look cheap on many conventional measures, they’re already had a rotten decade, and the global economy is bound to pick up eventually. 

History also suggests that investing in the stock market is a sensible move. Over the last century, shares have outperformed cash in 90% of ten-year periods.   

If you don’t want to take the risk of investing in the stock market, fine, put your savings into cash or bonds. (Or maybe property.) But whatever you do, don’t go for an absolute return fund. They’re risky, expensive and deliver poor performance. I really can’t see any virtue in them whatsoever. 

More:  The best way to boost your wealth | Nasty small-print surprises