ABSOLUTE RETURN FUNDS FUND GUIDE

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1 ABSOLUTE RETURN FUNDS FUND GUIDE Absolute Return funds aim to produce a positive return in all market conditions. This guide explains how they try to do this and the risks involved.

2 2 This guide is part of the information we provide to help you decide whether Absolute Return funds are right for you. It should be read together with your Key Features documents. We aim to use language that s easy to understand. Sometimes, however, because of the way investments work and in particular, Absolute Return funds we ve no choice but to use some technical terms. Wherever possible, we ve tried to explain each point in full. You ll already be familiar with some of the terms used in this document having read your Key Features documents, but many may be new to you. If you re unclear about anything at all, your adviser will be happy to answer any questions you have. ABSOLUTE RETURN FUNDS AT A GLANCE. They aim to deliver a positive return over a period of time, regardless of market conditions. They aim to produce a return higher than that available in cash deposit accounts. They use complex investment techniques to try to achieve their aims, some of which can be high risk. There is no guarantee of returns. You could get back less than you invest.

3 3 QUESTIONS AND ANSWERS What are Absolute Return FUNDS? The term Absolute Return refers to a range of funds that aim to give a positive (or absolute ) return in all market conditions. Each fund will specify over what period it aims to achieve this positive return. Of course, as with traditional funds, the aim might not be achieved. They can invest in a wide range of assets and can use complex investment techniques to try to achieve their aim of making a positive return, even in falling markets. WhAT are the RISks? Like all investment funds, their value may go down as well as go up and returns are not guaranteed. These funds may not achieve their aim of providing absolute returns and may suffer losses. Where the fund uses a contract with a third party, there s a risk that the third party is unable to meet its obligations. This means the fund may suffer losses. The fund manager will make a variety of investment decisions to produce returns in various market conditions. Those decisions may prove to be wrong, resulting in losses or returns that are not in line with the aims of the fund. WhAT do they TRy to do? It s important to remember that the performance of these funds is not related to stockmarket indices, for example the FTSE 100 Index. Absolute Return funds will typically target a specific level of return, usually above what you can earn on a cash deposit account. Often, the target return is linked to a commercial interest rate, like those used by the banks, such as LIBOR (London InterBank Offered Rate). The fund may then aim to deliver an additional, say, 4% each year, averaged over a three to five year period. Whether the stockmarket is up by 25% or down by 35%, the fund s target will not change. This means that a fund aiming to perform in line with the stockmarket may achieve greater returns than an Absolute Return fund in a rising market. Please note that any target returns included in fund aims are targets for the fund manager and not a guarantee. They will also be quoted before any fund or product charges have been deducted so if a fund manager meets their target, the growth on your fund will be less than the amount quoted.

4 4 How do they WORk? They can invest in a range of assets and derivatives. Some will invest purely in derivatives; others will invest in a combination of the two. The fund manager will use a variety of investment techniques and derivatives to achieve the fund s aim of gaining positive returns, even when investment markets are falling. These include: Selling assets at a high price, then buying them back at a lower price at a later date. Arranging contracts to buy or sell assets at a set price in the future. Arranging contracts that become payable in the event of company or government loan defaults. For more information about derivatives and the techniques used, please see What techniques does a fund manager use? starting on page 6. How might their returns COmpARE to TRADITIONAL FUNDS? There are many different types of traditional funds, all of which can work differently. One of the most popular types of fund is one that will invest in UK company shares. The returns on this type of fund would broadly follow the ups and downs in the UK stockmarket. As we ve previously mentioned, the returns on an Absolute Return fund don t aim to be in line with those of the UK stockmarket. This means that when the UK stockmarket rises, a fund investing in UK company shares is more likely to have higher returns than an Absolute Return fund. This also means in times of large falls in the UK stockmarket, an Absolute Return fund will still aim to provide a positive return, while it s likely that a fund investing in UK company shares will see a fall in value. While an Absolute Return fund aims to provide positive returns in all market conditions, there s no guarantee that this aim will be achieved. They can still experience significant falls in value.

5 5 Why is the FUND manager important? Absolute Return funds try to beat returns from cash deposit accounts, in all market conditions. To achieve this, the fund manager must invest in assets that give the potential for higher returns than cash deposit accounts. With this higher potential reward comes a higher potential risk of loss. The fund manager and their supporting team is vitally important in judging the level of risk the fund is exposed to against the potential rewards needed to achieve the fund s aim. The fund manager will seek various opportunities in the market and may use several investment techniques based on their fund s objectives. Not all Absolute Return funds are the same. Different managers will employ different strategies and take their own view on the markets, so performance between Absolute Return funds will vary. Some funds target higher returns than others and will therefore have to take more risk. It s important to understand Absolute Return funds are highly dependent on the ability and judgment of the manager and their supporting team. Who are Absolute RETURN funds SUITABLE for? You should only invest in these funds if you are confident that you understand how the funds work and what their risks are. Absolute Return funds can be used as part of a balanced portfolio of investments to help reduce the reliance on any one particular type of asset. The funds might be appropriate for you if: You re an experienced investor and are aware that investments can go up and down. You re prepared to invest for at least five years, ideally longer, and can be flexible when you cash in your investment. There is no fixed term. You understand the principles of investing and are comfortable with fund managers using a variety of techniques to invest, including those explained on page 6 onwards. You re willing and prepared to accept the risks associated with your investment and any fluctuations in value. Who are Absolute RETURN FUNDS NOT suitable FOR? You should not invest in Absolute Return funds if: You re an inexperienced investor. You re uncomfortable with the risk of losing any of your money through investment. For example: You have only ever held deposit accounts, protected or guaranteed investments. You re not prepared to invest for five years or may need to access your money early. You aren t confident that you have a basic understanding of how these funds work. You want to use the fund as your only investment or main portion of your range of investments.

6 6 What techniques does a FUND manager use? The following sections give a summary of a few of the techniques an Absolute Return fund manager may use. Some of these techniques may also be used in traditional funds, but they re more commonly used in Absolute Return funds. ShORT SELLING This is a way of profiting from a company s share price going down. Most investors buy shares with the hope that the price will go up. But it s also possible to make money when the opposite happens. How does it work? If a fund manager predicts that shares in a certain company will go down in value, they can borrow the shares from someone who owns them, for example, a large investment bank. The fund manager can then sell the shares. If the shares do go down in value, the fund manager can then buy them back at a lower price and return them to the lender, making a profit in the process. If the shares go up in value, the fund manager would then have to buy them back at a higher price to return them to the lender, making a loss in the process. Example: Shares in XYZ Ltd are today valued at 1 each. Andrew predicts that these shares will go down in value over the next few months. Andrew borrows 1,000 shares from Big City Investment Bank for a period of three months at a cost of 50. Andrew sells the shares for 1 each, receiving a total of 1,000. Three months later, Andrew is now due to return 1,000 shares in XYZ Ltd to Big City Investment Bank. Shares in XYZ Ltd are now valued at 80p each. Andrew buys 1,000 shares at 80p each costing him a total of 800. He then returns the shares to Big City Investment Bank. Andrew s profit is calculated as follows: received from selling the shares 1,000 Paid to buy the shares Paid to borrow the shares - 50 ProFIT 150

7 7 Use of DERIvATIvES A derivative is a contract between two parties usually giving the right or obligation to buy or sell assets at a set date in the future. The two simplest types of derivative are Futures and Options. Futures These are contracts to buy or sell an asset at a certain date in the future at a set price. Within this contract one party agrees to buy the asset for a fixed price on a fixed date and the other party agrees to sell the asset at that price on the agreed date. Both parties have to carry out the transaction. A seller in a futures contract will be hoping they can sell their asset at a price higher than the market value at that time. A buyer in a futures contract will be hoping they can buy the asset for a price lower than the market value at that time. If the price of the asset is higher than the market value, the seller will make a profit and the buyer will make a loss. However, if the price of the asset is lower than the market value, the seller will make a loss and the buyer will make a profit. Futures can also be known as forward contracts or forward transactions. Example: Shares in XYZ Ltd are today valued at 1 each. Andrew does not hold any shares in XYZ Ltd but predicts that they will go down in value over the next few months. Big City Investment Bank predicts that shares in XYZ Ltd will go up in value in the next few months. Andrew enters into a futures contract with Big City Investment Bank. Andrew agrees that he will sell 1,000 shares in XYZ Ltd at 1 per share to Big City Investment Bank in three months time. Three months later, the shares in XYZ Ltd are valued at 80p each. Andrew then buys 1,000 shares costing him a total of 800. Andrew sells his 1,000 shares at 1 each to Big City Investment Bank receiving a total of 1,000. Andrew s profit is calculated as follows: Received from selling the shares 1,000 Paid to buy the shares ProFIT 200

8 8 options These are contracts that can be purchased to give the holder the option of buying or selling an asset for a fixed price at a fixed date in the future. There are two basic types of option: A call option this gives the holder the right, but not the obligation, to buy an asset at a fixed price on a fixed date in the future. A put option this gives the holder the right, but not the obligation, to sell an asset at a fixed price on a fixed date in the future. Options are similar to futures contracts, except the holder has the right to decide whether or not to take up the option within the contract, and so will pay a fee for that privilege. The holder will only use the option if it s in their interests, for example, if it allows them to buy an asset cheaper than its market value. If the holder doesn t use the option, then they will have lost only the fee they paid for the option. The option seller will hope that the option isn t used, so they ll profit by receiving the fee. Example one: Shares in XYZ Ltd are today valued at 1 each. Andrew does not hold any shares in XYZ Ltd but predicts that they will go down in value over the next few months. Big City Investment Bank predicts that shares in XYZ Ltd will go up in value in the next few months. Andrew buys a put option from Big City Investment Bank at a cost of 50. The option enables him to sell 1,000 shares in XYZ Ltd at 1 each to Big City Investment Bank in three months time. Three months later, the shares in XYZ Ltd are valued at 80p each. Andrew then buys 1,000 shares costing him a total of 800. Andrew then exercises his put option and sells his 1,000 shares at 1 each to Big City Investment Bank receiving a total of 1,000. Andrew s profit is calculated as follows: Received from selling the shares 1,000 Paid to buy the shares Cost of buying the option - 50 ProFIT 150 Example two: If in example one the share price had risen to 1.20, instead of falling, then Andrew would not use the option as he would have to pay 1,200 to buy the shares, which he could only sell for 1,000. He therefore makes a loss of 50 the cost of buying the option in the first place.

9 9 Credit default swaps This is a more complicated type of derivative. It s a contract where one party will pay another in the event of a company or government failing to make repayments on their loans ( defaulting ). The buyer of a Credit Default Swap doesn t necessarily need to have loaned out any money. They may just believe that there is a good chance of a particular company or government defaulting and is willing to pay a fee for a contract that pays out in this event. The seller of the Credit Default Swap will base the price of the contract on their opinion of the likelihood that the company or government will default, together with the amount they agree to pay out. The seller of the Credit Default Swap will hope the company or government is able to make all loan repayments and will profit from the fee paid by the buyer. Example: Andrew believes that XYZ Ltd is likely to default on their loan repayments within the next five years. Big City Investment Bank believes that XYZ Ltd is not likely to default on their loan repayments and is selling Credit Default Swaps. Andrew buys a Credit Default Swap from Big City Investment Bank that will pay him 1,000 if XYZ Ltd defaults on their loan repayments within the next five years. The Credit Default Swap is priced at 3% of the payout value each year. This means that Andrew will pay Big City Investment Bank 30 each year for the length of the contract. Three years later, XYZ Ltd goes bankrupt and default on their loan repayments. The Credit Default Swap contract ends and Big City Investment Bank pays Andrew 1,000. Andrew s profit is calculated as follows: Received from Big City Investment Bank 1,000 Paid to Big City Investment Bank (over three years) - 90 ProFIT 910 There are many other techniques and derivatives that an Absolute Return fund manager may use. Some of these can be very complicated, but many are generally based on the techniques we ve explained here. How can I get further information about ABSOLUTE RETURN FUNDS? Please speak to your adviser who will be happy to help.

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