The absolute return sector may have attracted some flak this year but, argues Smarter Business Roadshow 2016 speaker Sam Liddle, it would be wrong to tar all funds with the same brush
Absolute return funds have attracted some criticism this year, with arguably the biggest gripe being that they failed to protect capital during the first-quarter sell-off in markets. While we would always argue a few months is too short a time to judge any investment, the continuing debate raises some important points about the nature of absolute return funds and how risk is managed.
To our mind, an absolute return fund should have a number of key characteristics. First, it should start with cash - and every investment beyond cash should offer a compelling reward potential, for an appropriate level of risk.
As an example, at the start of this year, we were finding relatively few opportunities that met those criteria and as such, were holding higher weights in cash and near-cash instruments. This proved serendipitous and yet our positioning was not because we foresaw a crash - it was simply a reasoned reflection on current valuation levels.
Absolute return also means ensuring every investment is made with an awareness of the downside risk and contributes to the diversification of returns. Standard equity and bond funds can ride market highs and lows - and can claim to have done their job if they lose less than the market. This is not a claim that can reasonably be made with an absolute return fund.
This is important because of the impact significant drawdowns can have on long-term returns. While, for example, a 10% loss in any one year would require an 11% gain to break even, a 30% loss requires a rise of 43% to break even - in other words, even relatively short-term losses can have a lasting impact. Avoiding these losses is a vitally important feature of any fund that claims to be ‘absolute return' in nature.
We monitor a range of securities at all times, setting alerts when they reach a price we see as attractive. We have a target valuation at each side. This might be a spread over gilts for corporate bonds or a target stock price for equities. We buy equities with a stop-loss, so that we know our maximum downside. We also have a trailing profit stop, which can prevent us from becoming ‘carried away' with a good idea. We look very specifically at each stock.
These checks and balances help ensure that we are not as vulnerable to the behavioural traits that can dent returns. A genuinely ‘absolute return' approach requires measures like these in place. It is important to understand the maximum downside of any position. In the bouts of market volatility seen this year, it is clear a number of absolute return funds have not been run with these risk measures in place.
When markets were volatile at the start of this year, we were in a good position to take advantage. We had cash and we knew where we wanted to invest. In February, for example, there were selective opportunities in the corporate bond market, where valuations were around 30% lower than their highs of a year ago (notably in financials). At the same time, in the stockmarket, we saw valuation opportunities emerge in companies such as BP. This is not timing the market - this is looking at stock-specific valuations and being disciplined.
Absolute return funds potentially have an important role to play in decumulation portfolios as part of the new pension rules. A genuine absolute return fund should be able to deliver reliable returns, so retirees can take regular withdrawals from the total return and preserve - or even grow - their capital over time. They cannot fulfil this role, however, if they are experiencing significant market directionality or drawdowns at any one time.
Some of the criticism directed at absolute return funds this year has, we would argue, tarred all funds with the same brush. There are funds that have protected capital during the bouts of market volatility - and that have even used the volatility to their advantage. Investors just have to pick with discernment.
Sam Liddle is sales director at Church House Investment Management and will be speaking at Professional Adviser's Smarter Business Roadshow, which visits Mere Golf & Country Club, Manchester on 18 October, Villa Park, Birmingham on 19 October and One Moorgate Place, London on 20 October.
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