Investor demand for positive returns in a bear market has worked against benchmarking
The definition of absolute return funds in the regulated retail world is a nebulous one, defined mostly by the intentions of the managers themselves.
Unlike absolute return hedge funds, regulated retail portfolios cannot short stocks or use leveraging as tools to achieve absolute returns. Despite that, we have ended up with a philosophy of absolute return in the management of retail funds.
This philosophy centres around whether a manager invests with regard to an index or has the flexibility to take positions unhindered by stock and sector weightings.
An example of this would be how fund managers, and the mandates under which they operate, approach a stock such as BP, which makes up some 8% of the FTSE 100. For a relative return manager, it would be too great a risk against the index not to hold a position in the stock, unlike a manager focusing on absolute returns.
Gartmore UK Focus is an example of a fund that could be considered to be run with an absolute returns mentality.
At the same time, special situations managers like Fidelity's Anthony Bolton and former Rathbones manager Patrick Evershed, are also considered to manage on a free-standing basis, meaning they have the mandate to select stocks from across the whole UK market, regardless of index weightings.
However, the stockpicking, aggressive focus funds that have been launched in recent months are considered to be completely different propositions compared to portfolios like Bolton's. Most of the focus funds tend to invest in their best ideas, aiming for a holding range of between 25 and 35 stocks. Bolton has more than 200 stocks in his £1bn-plus Special Situations fund.
Over the past 12 months to the 6 March, when the FTSE All-Share fell 9.93%, Gartmore UK Focus returned 14.6%, compared to the UK All Companies average return of -14.6%, a performance gap of 29.2%. It was only one of two funds out of 285 in the sector that achieved positive returns over that period.
While Fidelity Special Situations did not achieve the highs of the Gartmore fund, it did not fall as far as the rest of the sector.
John Husselbee, director at Hendersons, said managers who focus on absolute returns never see the complete rise of a climbing market but never capture the lows either. Over a one-year period, Bolton's fund fell 3.5%, Rathbones' Special Situations fund fell 1.7%, GAM UK Diversified, managed by Andrew Green, dropped 3.8% and Marlborough UK Equity Growth, run by Michael Barnard, achieved a positive return of 0.4%.
John Ross, senior portfolio strategist at Fidelity, said he defines an absolute fund as one that is not benchmark orientated, where the manager deviates markedly from index or market weights in terms of sectors, countries or stocks.
While he admits Bolton, along with Fidelity managers KC Lee and John Muresianu, all have unconstrained investment mandates, the group also runs funds that are managed with an eye to their specific indices.
John Dodd, director at Artemis and manager of its smaller companies portfolio, said he would consider a manager such as John Walton of British Empire Securities investment trust to be an absolute return manager.
Walton pays close attention to reporting in his accounts, identifying the opportunities he sees in the market and showing the value they have added to his portfolio. Artemis, Dodd said, runs the majority of its funds away from benchmarks and he would also consider Fidelity to be an absolute manager.
The offshore BDT Invest Global portfolio has taken the attitude towards absolute returns one step further than straight stock picking by using cash instruments as a tool to achieve positive returns in a falling market.
Under Ucits rules, a fund manager can hold no more than 10% in cash, but the portfolio's mandate, which invests in the Far East, Japan and emerging markets, uses cash instruments to get around this rule and generate returns.
Listed in the Standard & Poor's Asset Allocation Global Flexible sector, the fund achieved bid-to-bid returns of 23.64% over the year to 8 March.
Manager Henry Thornton said the fund was only 25% exposed to equity markets in July 2001, moving to 40% exposure in September and up to 80% immediately after 11 September, benefiting from the boost emerging markets saw in October and November.
The flexibility of using cash instruments to get out of the market at times of great volatility gives managers an extra tool to achieve absolute returns, he said. However, this flexibility comes at a price. Its sector is not mainstream and attracts limited attention.
Onshore, the equivalent of this kind of mandate, is the balanced managed sector. Again, while the use of cash instruments might be an advantageous way of running an absolute fund, the balanced managed sector has less appeal for UK investors than the All Companies peer group, making it a more difficult sell, according to Mark Dampier, head of investment research at Hargreaves Landsdown.
Another supposed defining characteristic of a retail absolute fund is the turnover levels in the portfolio. Some relative return funds tend to hold onto stocks with an investment horizon in mind, although this does vary from manager to manager.
These horizons can be anywhere from months to years but pure stockpickers rarely like to be drawn on how long a stock is held. With absolute in mind, the horizon can be hours to several years. The length of time a stock is held is proportionate to what the manager feels it can add to the portfolio.
Thornton said: 'By definition, it is harder for a relative manager to have a sell discipline as the mandate forces him to hold certain stocks. We have no investment horizon, only objectives. Portfolio turnover is a by-product of the process, not a limitation on what we are trying to achieve.'
However, Ross argued, this applies to relative managers as well, the only difference being that sometimes the relative manager is forced to maintain certain exposure levels.
He said: 'If a relative return manager buys Shell rather than BP because they believe it is a better story and it does really well but then hits its target share price, the manager sells. He then has to buy another holding in the energy sector to have exposure.
'However, the reason he has traded could be the same for an absolute return manager. The two are buying and selling for the same reason but the absolute manager is not forced to do so.'
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