Pensions Week: Intermediate guide to absolute return investing
11 May 2009
A guide to absolute return investing: part two
In the first article in this three-part series, we explained that absolute return funds aim to deliver (through the efficient implementation of investment risk) a positive return greater than leaving cash on deposit. We then went on to describe what makes a good absolute return fund: a broad range of diversified investment strategies implemented in a liquid and transparent manner in a regulated investment vehicle. Investors are attracted to these funds for their longer-term returns and their lower levels of shorter-term volatility than traditional equity investment.
In this article we dig a little deeper. We look at the different types of funds and the issue of market timing.
Diversified Growth Funds
Diversified Growth Funds (DGFs) offer a more diverse range of asset classes than traditional managed funds. In recent years, we have seen increasing allocations to assets such as high yield bonds, emerging markets, private equity, commodities, infrastructure and hedge funds.
For some funds, these allocations are passive in nature: fixed investments irrespective of the investment environment. Other investment managers are encouraged to be active in their asset allocation decisions within this range of strategies.
However, there are concerns over both of these approaches. For passive, there will be allocations to asset classes even when the expected outcome is negative. For active managers, they can suffer from the benchmark hugging characteristics that plague many managed funds. When managers have one eye on a strategic benchmark, they will often start from this as a neutral position and work out from there.
A second flaw in these funds has come to light in the past year. It is that most of a manager’s permitted asset classes – all those described above as well as global equities and property – are linked to global growth. The past year has seen global growth turn to recession; all of these assets linked to growth have fallen and therefore failed to provide the diversification they promised.
Absolute Return Funds
Is it possible to achieve positive investment returns when economies are contracting? Absolute return funds give investment managers more scope to diversify a fund and deliver returns from strategies that take advantage of both growth and declining growth conditions.
An absolute return target gives fund managers an unrestricted investment universe. This avoids peer-group benchmarking or clinging to a ‘strategic’ benchmark. This strategy frees the fund manager to invest in different geographies and markets, investing wherever they see the best prospects. The breadth of opportunity means managers can respond to changing conditions and minimise the use of investment strategies and assets that are correlated.
Effective absolute return strategies need an investment process that combines dynamic allocations to traditional assets, such as equities, bonds and property, with more advanced approaches. The result is a fund that actively maintains a well diversified position, offering the possibility of positive performance regardless of individual market conditions.
The investment freedom of the absolute return approach comes with a responsibility for robust management of investment risk. This is best achieved by restricting the contribution to overall risk that comes from each position. This risk-based approach to portfolio management helps transparency, ensures true diversity and demands that all risks must be clearly understood.
Solving the ‘gambler’s dilemma’
Is this the right time to invest in absolute return funds? Whilst some pension trustees may like the overall proposition of absolute return funds, they are faced with a difficult decision. With their equity portfolios having lost so much in recent times, there is the natural tendency to want to hold onto these equities and hope they will recover and to avoid ‘crystallising a loss’ by selling at these levels. As markets have moved lower, and further impinged on the solvency of schemes, this reluctance to sell has been increased.
Trustees are faced with the following choice
- high probability of a modest level of positive return for a low level of risk by investing in an absolute return investment strategy
- potentially much higher returns, albeit with significantly greater risks to capital by staying in equities
This is known as the gambler’s dilemma.
The key issue is would schemes be crystallising a loss by moving from equities to absolute return funds? Trustees’ recent experience of moving out of equities was to re-allocate this money to bonds. While this lowers the volatility of the scheme, it also has two negative effects. First, bonds have lower expected long-term returns than equities. Second, because of this, pension schemes’ actuaries need to use a lower discount rate to assess the funding level of the scheme. The result of this is a larger deficit and requirement for the sponsoring company to increase funding – and in current economic conditions the sponsoring company will be looking to invest in the company rather than the pension scheme.
What is also true is that should there be a significant equity market bounce, absolute return funds will be unlikely to match this. However, pension scheme actuaries can use a similar discount rate as equities as long as the investment objective for the absolute return fund is similar to a long-term level of equity return: in this case, there should be no change to a scheme’s funding level.
In addition, volatility levels are lower than with equities, so returns are more predictable. This improves the ability to achieve decent long-term returns with less chance of nasty asset price declines, as will have been the case for equity investors in 2008.
Next Week
In the third part of our three week series, we look at some of the different types of absolute return funds, compare them with diversified growth funds and explore in more detail how they can be used to improve the solvency position of a scheme. We also ask is now the right time to be investing in absolute return funds?
Malcolm Jones, Investment Director – Strategic Solutions, Standard Life Investments
3 Highlights –
- Diversified growth funds are highly reliant on economic growth to provide positive returns
- Absolute return funds can offer a broader universe of investment strategies to give returns
- Irrespective of the level of equity markets, absolute return funds make good financial sense for pension schemes
