When is an absolute return fund not an absolute return fund?
This article first appeared in FE Trustnet.
You could probably start to answer that question by determining what an absolute return fund actually is. The accepted definition is a positive return. More specifically, a positive return regardless of market conditions. Not a particularly ambitious return target for an investment strategy admittedly, but a starting point none the less. However, a quick look at the IA Targeted Absolute Return sector, where retail absolute return funds mainly reside, shows you that it’s seemingly not that easy a target to meet. The sector average posted a negative return of -0.3%, over the past year. Not a particularly good endorsement for the industry. Amongst the 88 funds in the sector at that point in time, 45 are in negative territory with 17 of those having absolute return in their fund name.
But perhaps it’s a little unfair to focus on a one year period. The sector itself defines its qualifying criteria as funds that aim to deliver positive returns in any market conditions. No time frame is set but it mustn’t be longer than 3 years. Things look a little better over that time frame, but still 25% of funds posted a negative return. Fortunately for them they won’t be ejected from the sector because the IA have generously stated that returns aren’t guaranteed. But perhaps they would be housed better elsewhere as they aren’t doing the sector any favours. There is a fund within the sector that fell -27.2% over 1 year and -24.7% over three. To call it an absolute return fund is a bit of a stretch. But by the same token the best performing fund in the sector has grown by 20.7% in one year and almost 90% over three. That is equally worrying.
For the objective of delivering an absolute return is not to provide a low performance hurdle for fund managers or an excuse to charge high fees. The return target is a consequence of the desire to provide investors with an alternative source of return to both equity and bond markets. The desire to offer a strategy that behaves differently to both these key asset groups and importantly offers the potential to generate positive returns in falling markets. That is the key. It is about offering low to no correlation to bond and equity markets. In other words providing something different as part of a wider portfolio. In rising markets are rising these funds are not expected to perform particularly well, and are not required to. Investors should be exposed to the upside of rising markets through other traditional investment strategies. It’s when markets turn that they will look to these funds to offer some protection.
So it’s not just about the return. It’s about displaying a low correlation to the market to which you are exposed and which you are seeking some protection.
Yes, absolute return funds can be highly speculative vehicles, amplifying the impact (both good and bad) of the decisions of individual fund managers. But these tend to be the speculative hedge funds that grab the headlines and should probably be avoided unless you particularly like that sort of thing. For the more conservative investor seeking a diversified portfolio that has the ability to smooth out the overall investment journey, absolute return funds with their ability to offer positive returns in falling markets offer a valuable addition.
Absolute return funds are often talked about under the banner of alternative investments. Those investment strategies that can offer something different to the traditional asset classes. And that is correct in that absolute return funds are alternatives but not all alternatives are absolute return funds. Most absolute return funds adopt non-traditional strategies, such as shorting, in traditional asset classes such as equities bonds and property. However many alternatives adopt more traditional long only, buy and hold strategies in less traditional asset groups such as infrastructure, commodities and currency. All are valuable additions to a portfolio and have the ability to deliver positive returns in a variety of market conditions. The IA Targeted Return sector is a melting pot of different strategies but doesn’t accommodate or represent the full range of alternatives available.
So an absolute return fund is not an absolute return fund when it starts to look and behave more like an equity or bond fund. That is, it delivers equity or bond like returns (or geared equity and bond like returns) for equity and bond like risk. Such a profile should be of little interest to an investor seeking to introduce alternatives into a broader portfolio. Instead an investor should focus less on the actual return (unless of course those returns are extreme like in our earlier example which should act as a warning flag) and spend more time looking for funds displaying low correlation to traditional assets, low market beta and low volatility. Where you find such characteristics you will have found a potentially useful alternative.
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