Investment Insights' fund manager Sonja Uys suggested advisors ask managers these five questions before putting client money in an absolute return fund:
1. What makes this strategy suitable in a liquid format? Some hedge fund strategies benefit from the limited partner structure, and don’t translate well into a mutual fund wrapper (think distressed credit or activist investor strategies). Make sure the strategy won't be constrained by the regulatory limitations over what a mutual fund can do.
2. What is the benchmark? Benchmarks for liquid alternative funds are all over the map, and some managers will argue they are irrelevant. But without a benchmark, advisors can’t explain the performance to clients, nor can they effectively hold the managers accountable.
3. What is the universe the fund invests in? In Uys’ view, an absolute return fund has to use derivatives and has to have the ability to go short. A simple long-short strategy without derivatives cannot, in her view, be considered an absolute return strategy.
4. What are the return characteristics you are trying to achieve? Managers of absolute return funds will usually fall into one of two camps: those that speak of delivering returns but with less volatility, and those that speak in terms of capital preservation. Both have their uses, but they are not the same, and advisors should know what they are getting.
5. How will you be achieving those returns? Most managers will use derivatives to buy protection; but dig deeper: Do they use general market hedges at the portfolio level? Or pair trades? Do the managers collateralize their positions, and if so, with what? Does the fund have “naked” exposure to dodgy bonds or low-yielding, but sage, bonds?