Investment Adviser - Absolute Returns
Absolute return funds have been hitting the headlines of late, and some of the headlines have not been particularly positive. Some articles have looked at returns over a particular time frame highlighting negative returns over that period. Others have chosen to highlight the difference in performance between top and bottom quartile funds with the potential for miss selling thrown in to the mix for good measure. It begs the question are these criticisms justified or is there something more to it? The answer depends to a very large extent on what were investors’ expectations when they invested in the fund in the first place.
If an investor bought into an absolute return fund expecting it to make money over all time periods, then clearly the articles highlighting any period of negative performance are quite clearly justified. On the other hand if an investor bought a fund of this nature as part of a wider portfolio, to add some diversification, as well as generating positive returns then it might not be so clear cut.
The dilemma investors are currently faced with is that markets have recently been through one of the worst financial crises in decades and one that looks far from being fixed. As a result many investors are understandably risk averse but at the same time recognise that the return from cash isn't beating the rate of inflation. So leaving cash in the bank is losing money on a 'real' basis.
Investors have to accept that even to stand still they must take risk. An obvious starting point is to look to bond markets, which has its merits, however many investors will be wary of the fact that bond yields are now at historic lows. So what about equities? Many argue that markets are cheap and offer good value, however they remain volatile and their return over certain periods over the last decade doesn't look that attractive. Furthermore, when the market becomes stressed, all risk assets are behaving similarly. Before the crisis an investor could expect to benefit from the diversifying effect of holding different asset classes. This diversification effect is becoming ever harder to find and is particularly evident in moments of stress. Our analysis doesn't point to this situation changing any time soon and investors should be prepared for high levels of volatility for some time to come.
So is an absolute return fund the solution to these issues? Some investors remain to be convinced, being sceptical about the funds benefits and concerned about their complexity. A growing number of investors are focussing on how an absolute return fund can enhance a wider portfolio, taking into consideration not only returns, but also the amount of risk taken. But how much risk and how much return should investors expect?
To make money in ‘real’ terms requires investors to take risk and generally speaking involves a greater reliance on a managers' skill. Like any active strategy there will be variations in managers’ performance and it is up to investors to look carefully at the skill set, expertise and track record of respective managers. Even the best will have to navigate periods where market conditions are more challenging. That said, the attraction for investors worried about the lack of diversification available from traditional assets is that they can introduce a different type of risk into their portfolio and one that is not entirely dependent on the direction of markets or health of the economy.
In a traditional long only fund risk is measured relative to a benchmark in which case, for example, a 'low' risk equity fund might only display 18% volatility whilst the index displays 20%. In most instances an absolute return fund will however be measured versus their cash benchmark which displays next to no volatility. As a result it is possibly more important to assess these returns in the context of how much risk they are taking. Particularly as generally an absolute returns funds' performance targets are not merely focused on return but they will also stipulate an expected volatility. For example, many are seeking to deliver similar returns to a long term investment in equities but with less volatility, others may restrict themselves to only investing in fixed income and as a result expect to deliver lower return but also consequently expect to take lower risk. The relationship between reward and risk is therefore key. Suggesting a mix of cash and equities as an alternative also misses the point, in my opinion, as it depends entirely on hindsight or the ability to time the market.
There are a number of factors which dictate decisions on whether or not to invest in absolute return funds and how to asses their worth within a portfolio. Yes, there are some complexities not so evident in traditional funds, but then generally speaking the risk adjusted return objectives of absolute return funds are more ambitious. Having realistic expectations about the levels of risk and the levels of return an investor is seeking is key to the decision making process. There needs to be a continued emphasis from fund management groups on managing expectations and educating investors. Is it worth it? I believe that the answer is yes - good absolute return funds will provide investors with diversification to a wider portfolio and good risk adjusted returns. Both of which are characteristics hard to come by but which are in high demand.
Tam McVie, Absolute Returns Specialist, Standard Life Investments
First published in Investment Adviser on 8th November 2011