In the latest in his regular series for Professional Adviser reviewing the hot topics that have been keeping him busy over the past month, John Husselbee reviews the case for absolute return and 'liquid alternative' funds
As deep-rooted bond bears, we have been watching rising yields in the sector with interest. While we still see a role for fixed income within a broad multi-asset portfolio, we have long been underweight the asset class and have balanced out some of this position using so-called alternative funds.
Over recent months - as many have come to believe bonds may have finally reached an inflection point - we have taken the opportunity to spring-clean our alternatives allocation to ensure it continues to serve its purpose.
Before discussing how we use these funds, it is worth considering the sector as a whole and addressing the performance concerns that continue to crop up.
Demand for absolute return and ‘liquid alternative' products has clearly ballooned in the challenging conditions that followed the credit crunch and there are now more than 100 funds in the IA's Targeted Absolute Return sector - plus a number of others dotted around the Global, Specialist and Unclassified peer groups.
This popularity is also apparent from the sales figures - the sector was the best net seller in 2015 and 2016, according to the Investment Association, heading the sales charts in nine out of 12 months last year. Overall, more than £5bn poured into the sector in 2016, in stark contrast to the £8bn-plus that exited equity funds.
As is so often the case, however, popularity has not necessarily translated into performance, and in a generally strong 2016 for funds - despite huge macroeconomic uncertainty - many of the limited number that lost money are to be found in the Targeted Absolute Return space.
Performance over the year ranged from gains of more than 20% to losses of a similar magnitude, with a third of the sector in negative territory. As would be expected, this has sparked questions about how these funds are functioning, particularly given the size and profile of some of the underperformers.
I would draw a couple of conclusions from this.
First is the fact that many funds in the sector have cash or inflation-plus targets and such ‘short-duration' assets have suffered in an environment of falling interest rates and bond yields. Cash by definition is the shortest duration asset and a backdrop that has clearly favoured longer-duration plays has had a part to play in weaker performance.
Dispersion of returns
Also, the sheer dispersion of returns shows this is not a sector that can be assessed in broad terms and any discussion of an ‘alternatives' peer group is largely pointless. Constituents have varying performance objectives and benchmarks and many even invest in different asset classes.
The only overriding aim for the Targeted Absolute Return sector is to produce a positive return over three years and it remains to be seen how the Investment Association might punish any funds failing to meet that goal.
With such a range of strategies in the alternatives space, it stands to reason the risk profiles on offer can differ widely and investors flocking to the sector as a perceived ‘safe haven' may come away disappointed. This is surely a key reason these funds have come under increased scrutiny from the regulator, which has asked providers to make it very clear exactly what their products are looking to deliver.
For our part, we initially see alternative products as providing low correlation to traditional asset classes and then divide potential holdings into hedge funds (or ‘return enhancers') and absolute return vehicles (‘risk reducers'). Both play important - but very different roles - in our portfolios, again highlighting that ‘alternatives' come in all shapes and sizes.
We currently have four main alternatives holdings, having rotated two as part of our recent review. Looking at additions first, we have introduced the TM Fulcrum Diversified Core Absolute Return fund on the absolute return side, favouring the large team and resources behind it, headed up by former Goldmans economist Gavyn Davies.
Meanwhile, we have added Jupiter Absolute Return as part of the hedge fund allocation, a play on the skills of manager James Clunie. He has a long track record managing absolute return funds and we believe Jupiter is a good environment for his talents.
On the sales side, we removed one UK-focused fund, preferring more global offerings as the anti-globalisation trade continues. We also sold a currency play in the wake of the post-Brexit devaluation of sterling - again favouring broader products.
John Husselbee is head of multi-asset at Liontrust
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