Raings agency Fitch has branded European Absolute Return (AR) funds "prone to performace disappointment" and "mis-selling" to unsophisticated investors.
Fitch's damning indictment of the sector comes with a warning of the need for investors to understand this "fast growing and sophisticated segment of the market".
The European AR fund market, as defined by Lipper categories, has grown by 80% since January 2009 to €140bn in assets under management (AUM) at March 2011, thereby passing the peak of 2007, according to Fitch's analysis.
Fitch forecasts the sector will continue to grow, driven by sales rather than performance.
AR funds aim for positive total returns on a consistent basis, irrespective of market conditions over the medium to long term.
However, there is a wide range of funds that share this objective and no commonly agreed definition of what effectively constitutes an AR fund, Fitch said.
"In Fitch's view, this poses an increased risk of misselling, as AR funds gain traction in the retail market," it said in a market update.
"With greater emphasis on liquidity and downside protection, AR funds are not meant to fully capture market upside, which results in modest returns, leading to potential disappointment for less sophisticated or informed investors."
Fitch said the growth in AR UCITS funds is partly due to the flexibility the UCITS III regulatory framework gives managers to meet investors' appetite for returns which are less dependent on market directions, and for protection of capital.
Paul Bruns and Elaine Parkes
3,000 left to transfer
Record numbers of people aged 90 plus
From 3 to 10 October