IT IS difficult to build a diversified portfolio because many assets considered defensive, such as UK gilts and cash, are either expensive or offer little return. One asset class that can fill this void is absolute return.

Absolute return funds are the marketing man’s dream because they are designed, but not guaranteed, to deliver positive returns regardless of the direction of investment markets. It should therefore be little surprise that the popularity of absolute return funds has surged since the financial crisis.

The funds are potentially able to achieve positive returns in all markets as they can profit from assets that are falling in value as well as those that are rising. They do this by a process called selling short, where they sell an asset hoping to buy it back at a lower price and net off their investment at a profit. The skill comes in knowing which assets to sell short and when.

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A relatively simple example is a strategy called pairs trading, where the manager may think that a company such BP is a better investment than a rival such as Shell. The manager would buy BP for half the portfolio and in the other half sells Shell short.

The advantage of this strategy is that it eliminates most of the factors that affect investment markets. If the market was to rise BP would make a profit and Shell would make an offsetting loss as it would go up too when the manager was hoping it would fall in value.

A profit would be made so long as the manager is correct that BP will do better than Shell and is therefore largely immune to stockmarket movements.

Managers do not do this with just one pair of stocks but might have 50 or so such pairs in their portfolio. Some others rank shares and buy the ones they like but also sell short the ones they do not. This tends to dampen the market movements but performance often remains correlated with markets and of course the manager needs to make the right decisions for the fund to make a profit.

Fund management houses have been quick to respond to demand and in recent years there has been a proliferation of strategies, some of which are very complex and difficult to understand.

Herein lies the problem with this asset class. A surprising proportion of funds have delivered absolute losses to investors over horizons of one year and even over three years.

At the end of the day, there are no risk-free returns above cash returns. While they aim to deliver positive returns, very few funds do on a consistent basis. Most aim to deliver positive returns over a three-year period but unlike conventional funds it is much harder to spot if they are going off course. The solution is often to invest in a number of these funds, employing different strategies with the aim of smoothing your returns.

The absolute return sector also contains a wide variety of funds, some of which are designed to be relatively safe and steady while others are designed to strongly back their manager’s views and so may be more boom and bust. It is therefore important to take care when selecting funds to look at volatility and other risk measures. Simply picking a top performer is less effective here than in other sectors.

Absolute return funds tend to rely heavily on the skills of the fund manager than many other strategies and as a consequence the funds have higher charges so investors need to be wary that these will not erode the returns, particularly when the funds employs a low-risk, low-return strategy.

One of the largest and best-known funds in the sector charges 1.5 per cent a year, which is twice what the management house charges for its more conventional equity funds.

David Thomson is chief investment officer at VWM Wealth.