Funds in this complex sector must be understood and judged on their own merits, writes City Financial's Anthony McDonald.
The IMA Targeted Absolute Return sector has been the subject of significant comment and debate over recent years.
The column inches dedicated to the subject certainly demonstrate that many investors are sceptical towards the concept and/or usefulness of the sector. We argue that the sector contains a number of attractive investment vehicles that merit consideration at either the core or periphery of investors’ portfolios.
However, the extreme range of mandates and objectives incorporated within the category means that it is often unhelpful to frame the analysis of the funds, or the decision to make a portfolio allocation, in the context of this IMA sector.
Can absolute return ever do what it says on the tin?
It is especially important for each fund to be considered and measured relative to its individual approach and target. In part, the opprobrium towards the sector results from grouping funds around a desired outcome rather than any particular investment strategy or focus.
There is a substantial diversity of mandates, even in the more traditional, input-defined investment categories and this is only multiplied when grouping all strategies seeking to achieve positive returns in any market conditions, with a maximum timeframe of three years.
One outcome of such diversity is the likelihood that strategies with more rigid styles or asset class or geographical exposures will struggle in adverse environments.
For example, emerging market equities and bonds endured a torrid period in 2013 and such a backdrop was challenging for the strategies in the peer group that focus primarily on the area: of over 50 funds in the sector, fewer than ten recorded negative returns in 2013 and around half of these focused on emerging market equities or bonds.
When they are placed within a sector with an ‘absolute return’ label, it is then easy for the naysayers to point to them to support the view that the concept is invalid. In practice, as with all peer groups, it simply means that the sector comprises a wide range of styles and fund manager abilities, reinforcing the importance of understanding and judging the funds on their own merits.
However, even allowing for these factors, many funds within the sector have yet to prove to investors their ability to deliver performance in different market conditions and, in particular, to be uncorrelated to the direction of underlying equity or credit markets over time.
This is partly because a significant number have been launched since the crisis in 2008 and the only meaningful blip in most markets since then was the sharp but short-lived weakness in the third quarter of 2011, when the peripheral eurozone crisis triggered substantial downturns in global equity and credit markets.
It is, nevertheless, instructive that more than three-quarters of funds in the sector endured negative performance in the third quarter of 2011, while an even greater proportion rose in value over the more positive market conditions of 2013, when UK equities rose 21% and higher yielding corporate bonds also performed well.
As a result, scepticism will rightly persist unless – and until – more funds in the sector prove to investors that it is a credible ambition to preserve and even grow capital when many other, more mainstream, investments are struggling.
When researching funds in the sector, our starting point is to understand the fund manager’s approach to risk. We look to understand their tolerance for performance volatility from the overall portfolio and, where relevant, from individual positions. We combine this with a practical understanding of how they combine positions in their fund, and the degree to which potentially offsetting positions are incorporated, to build expectations of the likely path of performance delivery.
Long/short equity funds are a large part of the sector and we help summarise this analysis by considering them on a spectrum of ‘market neutral’, ‘conditionally directional’ and ‘directional’.
This helps understand their potential sensitivity to underlying equity markets and the degree to which this might adjust over time.
It can be challenging to find attractive funds that are truly ‘market neutral’, in part because it is difficult to add meaningful value consistently through relative value trades.
However, Absolute Insight Equity Market Neutral and Kames UK Equity Absolute Return are two funds where we have confidence in the managers’ ability to deliver attractive performance while minimising their sensitivity to equity market moves (in either direction).
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