EUROPE - Absolute return funds have failed to achieve their own investment objectives in the last 12 months, according to research conducted by funds ratings agency Standard & Poor's.

Analysis of 21 absolute return funds in the year to March 31 2007 reveals not only did all these funds included in S&P's Funds Services miss their own goals but most actually failed to match the performance of cash.

Absolute returns, or benchmark-free, funds are becoming increasingly popular with European institutions as an investment strategy, as they are designed to preserve the investor's capital and give an absolute return slightly higher than cash, whatever the market conditions.

However, Kate Hollis, lead analyst at Standard & Poor's, said all of the UCITS funds included within S&P's absolute returns sector fell short of their return targets, after fees, because of difficult conditions in the fixed income sector.

More specifically, Hollis said the cause of the problem was many funds had "incorrect duration positioning at some point" and the risk management processes of some asset managers prevented them from responding effectively to market developments.

More notably, she pointed out around 75% of funds are fixed income-based and absolute return equity fund managers have been somewhat slower to adopt the use of fixed income derivatives to counter market activity.

"A number of funds also had reasonably high exposures to emerging market debt and these were caught by the emerging debt wobble in Q2 of 06," added Hollis.

Underperformance was seen across the board, whether funds applied quantitatively-driven investments models or fundamentals strategies, and Hollis noted fundamentals-driven multi-asset funds suffer in particular because funds became more risk averse in their attitudes towards emerging debt, emerging equities and commodities.

She cited The Pioneer Investments Total Return and Fortis Absolute Return offerings as being badly hit, recognizing this is the first time these two companies absolute return funds have had "disappointing years".

That said, Hollis is aware some absolute return funds are now in course to reach their targets by year-end and most are recovering sufficiently to outperform cash.

S&P does not include or ‘rate' all funds from the absolute returns sector and looks only at those which are seen as having the potential to achieve their returns and risk targets consistently. There are currently thought to be a total of 70 funds in the present absolute returns universe.

"We have never believed there is a magic bullet process that turns a mediocre [fund] manager into a good manager and in difficult markets it is not surprising the mediocre fund managers will struggle," continued Hollis.

"It is evidence you can't just select a fund because it offers Libor +2% or Libor+3% without taking account of the quality of the investment manager," she added.