Fitch Ratings says that European Absolute Return (AR) and Multi-Asset Flexible funds did not always perform well and provide investors with sufficient downside protection during the market volatility this month.

European AR funds lost 2.5% and Flexible funds lost 7.6% in the first three weeks of August, according to aggregate data from Lipper. This results in a year to date negative performance of -3.5% and -8.9%, respectively. Not all funds in the top quartile of European AR funds have managed to preserve capital year to date. Flexible funds avoided 70% of the August market decline. However, only half of them outperformed a balanced bond and equity allocation YTD.

AR funds aim for positive returns in all market environments. Flexible funds aim at providing asymmetric returns relative to a balanced bond and equity allocation by dynamically changing market risk exposures.

"Making up for the 2011 losses has become a major challenge for many Absolute Return and Flexible funds," says Manuel Arrive (pictured), Senior Director in Fitch's Fund and Asset Manager rating team. "As a result, the worst performers are likely to be driven out of the market, as investors discriminate based on performance."

The magnitude of the general market selloff in August caught investors by surprise. Many asset managers were too slow to lower their portfolios' overall risk budget or move into cash. In addition, Fitch's analysis indicates that downside protection mechanisms such as hedging strategies at times proved ineffective.

Fund return dispersion (ie the difference in performance between funds) has increased in August, particularly in the lowest quartile of funds by performance.