David BurrowsIn simple terms an absolute return fund is designed to make a positive return regardless of the underlying market condition whatever asset class it is invested in - be that equities, bonds or a combination of assets.
Absolute returns contrast with ‘relative returns’ where a fund manager’s performance is measured relative to a benchmark, usually an index such as the FTSE All Share or S&P 500.
In a ‘relative returns’ universe an investor or fund manager could congratulate themselves on outperforming the index by 10 % but they could still have lost 20% if the market was down 30% overall. Not much to celebrate really.
Absolute return funds are different from traditional, long-only funds as they are less dependent upon the direction of the underlying markets.
Trading derivatives allows you to make money in a falling market. Credit: PAUse of derivatives
This is because the fund manager can use a wide range of investment tools, such as using derivatives to ‘short stocks’. Single-stock short selling enables a profit to be made if a selected company’s share price falls as anticipated.
Short selling, in itself, is fairly straight forward. It involves the sale of a security that is not currently owned on the view that the price of that security will, in time, fall in value and be bought back at a profit. Using derivatives makes that even easier as the fund managers need not borrow the actual assets being shorted.
But as with all stock market investment the skill is in identifying the right opportunities at the right time.
Whereas long-only investors will look for hidden value in unloved or under-researched stocks; an absolute return investor will also look for companies that may be overvalued or the bad news in their sector has been under-played. Alternatively, a manager may just be hedging a sector in general rather than taking a specific stock view.
So, are absolute returns are the perfect solution for risk averse investors who just want the guarantee of a positive return no matter what? Well, not exactly. As all marketing literature attached to an absolute return fund will testify, the word ‘guarantee’ is never used.
Saying you are going to deliver absolute returns and doing so (on a consistent basis and in different market conditions) are two different things.
Mixed performance
As far as track records go, absolute return investing has its shortcomings. If you consider periods such as mid-2011 when equity markets fell significantly or May/June 2013, when both bond markets and equity markets fell, it is evident that the majority of funds in the absolute return sector struggled to make positive returns.
Without doubt, performance of funds in the absolute returns is sector is extremely variable. Looking at five-year performance figures, the top performer is City Financial Absolute Equity, with +99.40%, and the worst performer is Threadneedle Absolute Return Bond, at -10.62%.
The average sector return over the past five years is +16.70%, compared to +57.79% as a sector average for funds in the UK All Companies sector.
One of the reason for such disparity in performance figures is the different natures of funds that are all broadly defined as ‘absolute return’ vehicles, as Patrick Connolly, certified financial planner at Chase de Vere explains.
“It is often difficult to directly compare Absolute Return funds as they can take hugely different approaches. Some use hedge fund strategies, others are focused on shares or bonds or adopt a multi-asset approach.
He adds: “It is therefore no surprise that their performance can differ hugely. Over the past year the top performing fund in the sector made a gain of 33% while the worst performer lost 13%.”
Understanding levels of risk is crucial to any investment strategy. Credit: PARisk levels
The fact that there is no single definition of what constitutes an absolute return can be problematic. To complicate things even further return targets will often differ from fund to fund too.
One objective could be to aim for cash plus X %; another might be LIBOR plus X% while another target might be simply to seek ‘a positive return in all markets’. Given the different make up and objectives of absolute return investments, it is almost impossible to compare like with like.
A manager could follow a bond-plus approach, using fixed interest securities, where the intention is to for a stepped return. Another manager might stick to a growth approach or a variety of hedge fund strategies - each methodology has its own risk characteristics.
Indeed, the various risk levels are something investors need to look out for, as Martin Bamford, chartered financial planner at Informed Choice explains. “Where absolute return funds are using financial instruments including derivatives, investors need to be aware of the risks involved and understand the strategy being followed. Other funds may follow a currency strategy, which can be incredibly risky when viewed in isolation.”
Does an absolute return fund really deliver in all conditions? Credit: PAAll-weather funds?
One of the reasons that performance in this sector has been mixed over the years is that the flexibility to go long and short – doesn’t always translate to investor peace of mind and suitable protection when markets go down.
As Connolly points out, too many absolute return funds are highly correlated to stock markets, so when markets fall they lose value, maybe not to the same degree as other funds but then they don’t capture all of the upside either.
When stock markets fell recently, 83 of the 101 funds in the absolute return sector lost money.
What protection they provide investors can be limited and the complex trading strategy inherent in their structure typically leads to higher costs.
It is perhaps understandable that ongoing charges on some of these funds are slightly higher than on conventional long-only funds. However, for products that are often trying to generate just a few percentage points of return, it is difficult to justify some of the performance fees that are charged.
As Connolly explains: “Performance fees are often charged at 20% of outperformance for beating a notional and irrelevant benchmark. That benchmark might, for example, be LIBOR rates which are currently around 0.5% per annum. This isn’t much of a hurdle.”
If a fund manager is confident in their ability to out-perform and wants to apply performance fees the fairest way is first to reduce the ongoing annual charge and second to introduce a meaningful performance hurdle. Fund managers don’t seem particularly keen to do this.
It is important to tread carefully when selecting an absolute return investment. Credit: PABuyer beware
We have already seen how performance levels can vary widely within the sector. There is undoubtedly some good performance out there, but investors need to understand what they are buying into and whether the underlying investment approach is aligned to their risk profile.
You might think you are investing in something that will give you a modest percentage over cash, but you find that you are in a long/short hedge fund with a currency overlay. Not what you may have had in mind. The key consideration is; has the manager spelled out what they are trying to do?
Without doubt some Absolute Return funds are taking too much risk and thereby potentially subjecting investors to major and unexpected losses.
In 2016, out of a total universe of 3,071 investment funds, three of the bottom four performers were from the Targeted Absolute Return sector. FP Argonaut Absolute Return lost 26%, CF Odey Absolute Return lost 18% and Old Mutual UK Opportunities lost 12%. These funds show huge volatility.
As Connolly points out: “It is astonishing that funds which supposedly aim to provide a positive absolute return can lose so much.”