Absolute return in name not nature?

Published by Cherry Reynard on 07 September 2010.
Last updated on 27 September 2010

Over the past two years, the absolute return sector has been one of the few to rival the corporate bond sector for popularity.

Investors have been seduced by the promise of all-weather positive returns and low volatility. But returns in 2010 have been disappointing, with half the sector showing declines in the year to date.

The average fund is down 0.5% since January 2010, according to Trustnet. This is not a disaster, but it does mean the sector is among the worst performers this year.

There have also been weak performances from some of the underlying funds. The Octopus Absolute UK Equity fund, for example, is down 17.9%.

Rob Burdett, joint head of multi-manager at Thames River Capital, says a lot of these funds were hit hard in May as all-risk (non-cash) assets moved down together. "It upset some of the funds" risk-management processes.

"Some of their risk controls effectively involve a 'stop-loss' system and while in normal conditions this works well, this time it meant that they were not exposed to the bounce when it came."

In Thames River Capital's in-house consistency filter - which measures outperformance against a benchmark over three years - not a single absolute return fund has made the grade.

The average over all sectors varies between 10 and 12% depending on the year, but every other sector has at least one fund that meets the criteria.

Equally, diversification is only as good as the views on which it is based. Marcus Brookes, head of multi-manager at Cazenove Capital, gives the example of the L&G Diversified Absolute Return fund: "It had been doing very well, having taken a very bullish view.

"Although it had different asset classes within its portfolio, all its positions reflected that bullish view and therefore it was hit very hard when the market turned."

Ben Yearsley, investment manager at Hargreaves Lansdown, says absolute return funds have only done one half of the job they promised to do: "Over a two-year period, a lot of the major funds in the sector are flat - BlackRock UK Absolute Alpha and Cazenove UK Absolute Target, for example.

"The market has fallen over that period, so they have done part of their job in terms of protecting capital, but they haven't done the bit where they said they could make money in any environment," he says.

It's not all bad news
Of course, there are also a number of caveats. Not all funds have done badly. The Standard Life GARS fund, for example, is up 7.3% year to date.* Equally, no one should be judging absolute return over six months.

Most set themselves a three-year rolling target and in that context, only two funds haven't made the grade (although only 13 funds in the sector have a three-year track record).

The approach highlights some problems. One is the sheer inconsistency of the sector. It contains funds that use fixed income, equity long/short and multi-asset strategies. Some aim to be entirely market-neutral, others to predict the direction of markets.

As might be expected with such a disparate sector, there has been an enormous variance in returns - from +7.3% to -17.9% over the year to date*. Over three years, the difference ranges from +43.2% to -14.9%.

Richard Pursglove, head of retail at Gartmore, says: "It is exactly the same as any long-only sector. There are myriad strategies within the absolute return sector, each with different characteristics."

He believes the sector is likely to be broken up as more funds are launched. He sees it as a different way of running money and suggests it could, theoretically, merit as many sectors as long-only equity funds.

Gavin Haynes, investment director at Whitechurch Securities, uses the Octopus fund to illustrate managers' differences in approach.

"The Octopus produced phenomenal performance in its early days, but it takes on significant market directional bets. It has never hidden that. It is a very different beast from the more conservatively run funds in the sector," he says.
The Aegon UK Equity Absolute return fund is one such fund. Manager David Griffiths says: "We want to deliver an absolute return regardless of the direction of the market or prevailing economic conditions. We want to run with low volatility and low or no correlation to the market."
He models all trades before enacting them to test their overall impact on the portfolio's risk. Griffiths believes the fund should be judged on different measures from a fund that aims to assess whether the market is moving up or down and position itself accordingly.

Does the case for absolute return funds still add up?

A standard criticism has been the funds' higher cost. However, these funds have not proved more expensive (although this may be because few have performed well enough to incur a performance fee).

Funds within the sector have an average total expense ratio of 1.87% with around 10 funds (of the 36 that have a long enough track record for a TER calculation to be made) in the sector costing more than 2%.*

In comparison, the average TER in the UK Equity Income sector is 1.89% with seven out of 77 funds having a TER over 2%.

There has been criticism that the sector has grown too fast and diluted the talent pool, affecting performance. However, this has not been borne out by statistics, with some of the most experienced managers such as Cazenove and SVM suffering the most.

Equally, fund selectors still see plenty of good people. "I like the sector and at this stage it is still very high quality," says Burdett.

"It has brought some talented hedge fund managers back into the scope of retail investors. There has been a lot of money going in, but the problem is a lot of investors hear 'absolute return' and think 'guarantee'."

So far this year, those funds that use fixed-income assets have performed better and seen less volatility than equity-based or multi-asset funds.

This is primarily because credit markets have not seen the same volatility as equity or currency markets. In 2009, the multi-asset funds performed best. Equity-based funds have not yet had their day in the sun.

Burdett believes the funds still have a place. The problem has simply been difficult market conditions - funds have had to negotiate a series of panics.

"There is still investment risk with these funds, and managers' views are going to be wrong from time to time," he adds.
Brookes agrees. "A fund manager has more flexibility with these funds, but he still needs to use it in the correct way.

People expect an absolute return in all market conditions, and that if the market falls, the funds won't follow. The trouble with the recent markets was that everything went down at once," he says.

As the sector is so disparate, choosing the right fund and getting the right balance in the portfolio is vital. "It is a different way of running money. It is not an alternative to long-only. These funds should be part of developing a balanced portfolio," says Pursglove.

As such, investors should be looking for funds that are uncorrelated or little correlated to the rest of their portfolio and that improve the overall diversification.

He adds: "The expectation should not be that they can't go down. They will experience periods of negative performance. Investors should be looking for low volatility and low correlation."

Whatever the name suggests, absolute return does not mean the funds will always go up. Investors should set aside any marketing spin about 10% returns in all market environments and ensure that they understand what the fund manager is trying to achieve.

Is the aim to grind out returns whatever the market conditions? Or is it trying to predict market swings?

More than any other sector, absolute return covers myriad styles and investors need to understand what they can realistically expect.

*Source: Trustnet

This article was originally published in Money Observer - Moneywise's sister publication - in September 2010

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