Absolute Return Funds - reducing the risk but what about the returns?

Posted by Liz Rees in Portfolio management category on 03 Feb 17

Multi Asset

Introduction to the IA Targeted Absolute Return sector

The Investment Association Targeted Absolute Return (IA TAR) sector requires Funds to be managed with the aim of delivering a positive return after fees in any market conditions, though this is not guaranteed. In addition they must clearly state the timeframe (up to a maximum of three years) over which they aim to meet their stated objective. A few years ago, the IA added the prefix ‘Targeted’ to the previous designation of Absolute Return sector 'to ensure there is no doubt that positive returns are a target and not a guarantee'.

The sector is comprised of a wide selection of Funds employing multiple strategies across many markets and asset classes. Funds on offer use differing timescales for their target return, don’t measure performance against a traditional benchmark and exhibit a wide range of risk levels. Consequently, performance comparisons across the sector are not really appropriate. Recent political uncertainty has likely contributed to the strong inflows into the category in 2016 which has regularly topped the Investment Association’s list of monthly best sellers. Net retail sales for the full year totalled £5.6bn putting it firmly in the No 1 spot.

Why might an investor consider this type of Fund?

In our recent Insight article we looked at the Multi Asset sector which has proved popular with investors seeking diversification through Funds which take care of asset allocation and hopefully smooth out returns. A number of AR (Absolute Return) Funds have such a mandate and in addition incorporate more complex strategies. Some have a target yield proposition which can be attractive to retirees who want a stable income and are less concerned about maximising capital returns.

Absolute Return Funds then go a step further and try to make money over the medium term irrespective of market conditions. Unsurprisingly, Funds which attempt to deliver such positive returns hold a strong appeal to investors in times of heightened volatility.

As the current ‘bull market’ is one of the longest on record it is evident that some investors have turned to the AR space as a potentially more secure home for their money if or when the inevitable ‘bear market’ arrives. While the timing of any downturn is impossible to predict it can’t be ignored that by the end of 2016 the bull market for the Dow Jones Index had extended to 93 months. This compares with a historic average of 36 months.

So if you are worried about issues like an economic downturn, political instability or current valuations, yet don’t want to exit the markets completely the sector may be worth exploring. However, the performance of some AR Funds over the last year suggests they may not all be the perceived safe haven that investors expected. We look at the tactics used and the pros and cons of these strategies then consider if they are still worthy of consideration.

Tactics used by Absolute Return Funds

Demand for Funds that aim to protect your capital against significant losses in a market downturn has risen since the financial crisis. Some AR managers will try to control risk tightly and produce modest but steady returns, while others are positioned far more aggressively.

As we noted, their diverse strategies are designed to deliver a variety of outcomes, and often involve the use of derivatives. Derivatives are used for 3 main reasons: managing investment risk to reduce volatility and preserve capital, to generate yield and to express a market view. A typical mandate is to deliver equity like returns with half the volatility of equities.

The managers balance short positions in assets they have a negative view on with long positions where they consider the outlook more positive and the Fund factsheet- or KIID- should indicate whether the Funds approach is net long, net short or market neutral.

A 'long' position is the traditional method of buying shares, in the expectation they will go up in value, while investors who 'short' stocks are betting on price falls. To short a stock the fund manager borrows shares (paying the owner of the shares a fee to do so) and then sells them in the expectation that they can buy them back at a lower price before they have to return them. The price at which they are repurchased is the profit or loss on the trade. If successful, the tactic can produce profits in a falling market but if a wrong call is made losses can be significant.

Market neutral AR Funds aim for zero net-market exposure so the fund's short and long positions have the same market value i.e. 50% long: 50% short. This strategy is designed to be lower risk than a long-biased strategy as it depends less on market direction. Nevertheless, performance still depends on the manager’s stock selection skills. Another methodology is to have a neutral position on a sector but within it select 2 stocks and be long of one and short of another; this is known as ‘pairs trading’.

If managers have a strong view on the overall direction of a particular market they may use derivatives known as call and put options to benefit from predicting the future direction of an index.

Multi Strategy Funds can take active currency positions via physical assets or derivatives. Currency options have lower volatility than equity protection and can be a lot cheaper. Some currency pairs may move in the opposite direction to equities and credit spreads during times of market stress, offering diversification benefits. Managers may also invest in alternative instruments only available to specialist investors. Some Multi Strategy Funds may put more emphasis on one approach than others so investors should consider the transparency and complexity of strategies undertaken.

The advantages of TAR Funds

They can provide valuable diversification from traditional equity and bond Funds, which tend to be long only (though there are exceptions), since they are likely to have less direct correlation with market movements. They aim to make money when markets are falling by shorting stocks or using futures and options, making them the closest vehicle to a hedge fund for the retail private investor.

Generally, there are considerable dispersions between the best and worse performing shares and sectors which should prove plenty of opportunities for those Absolute Return managers who are capable of identifying the winners and losers. For example, the 19% return of the FTSE 100 in 2016 disguises the fact that sectors such as oil and mining companies were extremely strong performers while others such as food producers and general retailers lagged behind.

The disadvantage of TAR Funds

There have been regulatory concerns that some Funds have a reputation for charging high fees and running complex strategies which are not clearly explained to individual investors. Indeed, the FCA is to investigate the TAR sector as part of a review of the asset management industry. One aspect to watch out for is the use of performance fees. Around 44 per cent of Funds within the IA Targeted Absolute Return sector charge a performance fee, according to data from FE Analytics.

As with all active Funds you are dependent on the skills of the fund manager and they may have spells of poor performance. Even Standard Life GARS, the biggest and longest established AR product, despite a resource of 70 managers, had a very disappointing year in 2016. It has admitted that it’s positioning around the oil sector trends, Brexit and Trump proved to be unfavourable.

Many Funds have been launched in the past 3 years so it is too soon to tell if they will achieve their target of positive returns over a rolling 3 year period. While they theoretically should be suitable for those wanting lower risk this has not always proved the case.

What sort of Funds reside in the Targeted Absolute Return sector?

The range of fund names and strategies in this field can certainly look confusing at first glance and it is important to investigate beyond the headline description to ensure you understand what you are buying. The sector includes variants of: Multi Asset, Multi-Manager, UK equities, Global equities, European equities, and UK and European bonds. Some Funds are exposed only to equities through long and short positions while others, especially those with ‘Multi Strategy’ titles, have a complex and go anywhere approach.

For example, Schroders Absolute Return Bond Fund has a flexible Fixed Interest mandate, taking positions in various instruments, geographies and currencies. Kames UK Equity Absolute Return Fund on the other hand has a UK equity focused mandate. However, both take strong views at a stock level.

Jupiter Absolute Return stands out due to its unique 3 stage process developed by its manager, former academic, James Clunie. Firstly, he does quantitative screening of 22 factors such as value, momentum and size. Secondly, he appraises shares on a reverse discounted cash-flow basis*. The third step is an analysis of the shareholder register to assess the motivations of investors.

A broader multi-asset approach may suit those seeking a degree of capital protection as different instruments are likely to perform well at different times. Like any Multi Asset Fund they invest in a range of asset classes and geographies but will take short as well as long positions. The best known and largest in the sector are Standard Life GARs, Invesco Perpetual GARS and Aviva Multi Strategy.

Has performance delivered against expectations?

Most Funds target a positive return over a rolling 3 year period while some are more specific. For example, BlackRock UK Absolute Alpha aims to deliver a positive return over a rolling 12 month period.

The chart below shows that broadly the sector has met the objectives of modest positive returns with lower volatility. The IA Targeted Absolute Return Sector has delivered 17.0% over the past five years (2012-2016) compared to Cash (Libor plus 3%) which returned 19.4%.

In 2008, when the financial crisis hit markets and the average Fund in the IA UK All Companies sector lost nearly a third of its value, the AR sector lost only 1.5%. However, delving more deeply into the sector it is evident that there is significant variation between constituent Funds on a year by year basis.

Absolute Return Performance 

Total return % 2016 2015 2014 2013 2012
Jupiter Absolute Return  10.2   5.9  -0.2  2.2  0.9
Newton Real Return    3.8   1.0   3.3  5.4  3.4
Schroder Absolute Return Bond    3.2  -3.0   2.7  1.6  6.9
Standard Life Global Absolute Return Strategies   -2.7   2.8   5.5  6.8  7.6
Kames UK Equity Absolute Return   -3.1   2.5   4.2  6.1  1.6
FP Argonaut Absolute Return -25.6 11.9 13.6 39.6  5.7
  Source: FE Analytics

[Top performers shown in green, worst performers in red]

The table above demonstrates that returns have been diverse and overall not impressive in 2016. We show a sample of AR Funds available on our Platforms, including the best and worst and points in between. Albeit a year of extraordinary events, almost a third (30 out of 93) of Absolute Return Funds posted a negative return. It serves as a stark reminder of the possible volatility, illustrating that those which excel in some years can subsequently disappoint.

Summary and conclusions

The idea of capital preservation and target yields, where incorporated, will obviously appeal to many investors particularly those in retirement but it is important to remember that risk levels vary considerably and achieving potentially higher returns will require taking more risk. Funds which are successful in protecting against market falls are unlikely to participate fully when markets rally strongly.

Sector-wide comparisons are not helpful since Funds follow such varied strategies to pursue positive returns in any market conditions, so you need to examine their individual approaches before you invest. There are single asset and multi-asset strategies, as well as long-only and long-short strategies. For example, an equity market neutral strategy with rigorous stop/loss discipline and risk controls is likely to have low volatility but also lower returns. On the other hand a long/short Emerging Market Debt strategy could produce higher returns but involve greater risk or volatility.

Investors are relying on the skills of an active manager as much as ever and many Funds do not have long enough track records to validate their credentials throughout an economic cycle. The costs of implementing these more complex strategies can be expensive so consider the possible higher costs of these Funds. Be aware that some may have performance fees.

Performance of TAR Funds has varied considerably and a good number have failed to impress, particularly last year. The message to take from this is that no matter how good a fund manager’s process is it won’t work all the time. If investment selection is poor, or the manager’s approach is at odds with prevailing trends or sentiment, then investors could experience negative outcomes.

First and foremost, whether using Absolute Return Funds as a stand alone investment or as a component of a diversified portfolio, always ensure they align with your objectives and risk profile. TAR Funds should not be seen as extremely low or risk-free investments and you are almost certain to experience down months. While they may deliver their objective of less downside in a falling market conversely they will probably lag a strongly rising market.

In conclusion, these Funds might warrant a place in a diversified portfolio but if you are not comfortable with the strategies used or find them too complex to understand it may be better to stick to a simpler Multi Asset Fund, some of which have portfolios matched to different risk profiles.

*This is a valuation technique which calculates the implied future growth rate of a company to assess whether it is higher or lower then the market is anticipating in its current rating of the shares.

Important Information: We do not give investment advice so you will need to decide if an investment is suitable for you. If you are unsure whether to invest, you should contact a financial adviser.

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