In a falling market, long-only managers find it difficult to produce positive returns but some fund managers find it a lot easier than others
Product providers are finding investors less than receptive to the argument they have lost them less money than the index would have done over the past two years.
Two years of negative returns and the possibility of a third is making fund sales difficult, with intermediaries and product providers alike forced to tell clients that a fund returning -10% over one year should be considered a good performer, outperforming the FTSE All-Share by some 3%.
Presenting performance and managing money on a relative basis became increasingly popular during the bull market run of the 1990s, especially as active managers sought a way to differentiate their service from that of passive funds.
Managers of pension funds also needed a performance guideline to show trustees they were fulfilling their mandate. A reference point was useful for managers and trustees alike as a guide to how well each was doing their job and fulfilling responsibilities to the end clients.
It is the downward turn in global indices combined with the stronger presence of hedge funds in the UK market over the past two years, however, that is creating a demand for absolute returns.
Hedge funds have been promoting themselves as having the ability of providing positive returns no matter what the market conditions. Many have proved this, with funds such as Gartmore's Alphagen Capella European long/short, run by Roger Guy, producing positive returns in every month since its launch in November 1999.
Hedge funds can short stocks but long-only portfolios cannot, so the methodology of running an absolute return type of fund is via a manager who invests without an eye to the index or a benchmark. Managers prepared to move away from the benchmark have been around for some time on a select basis, with the likes of Fidelity's Anthony Bolton or former Rathbones' manager Patrick Evershed relying on their stockpicking ability to produce positive returns. Other methods are 'best idea portfolios' or what are more commonly referred to these days as focus funds.
Banking on a fund manager's stockpicking skill, ability to be nimble, comparatively small size of the portfolio, low correlation to indices and high levels of turnover, the funds do not promise to always produce positive returns but that is their aim.
Known stockpickers, such as Bolton, have tended to run their portfolios on a contrarian approach, allowing outperformance in investment periods when the average fund has been down. However, they have also suffered periods of underperformance when their particular investment style is out of favour with the market.
Robin Stoakley, managing director at Schroders, said with a market rising year-on-year as it broadly did in the 1990s, there was no real need for managers to target absolute returns, as performance against the benchmark was sufficient.
However, following a couple of bear market years, the market has seen the emergence of more aggressive stockpicking portfolios, trying to emulate what institutional investors can access via hedge funds.
John Husselbee, director of Henderson Global Investors' multi-manager funds, said some stockpickers in the market have always been able to provide consistent returns because they pay more attention to producing positive returns then they do to just outperforming an index.
He cited GAM's UK Diversified fund, consistently top quartile over the past 10 years, as being one such portfolio, as manager Andrew Green has always been open to holding a non-index weighting.
Husselbee said: 'Equity markets in the past 25 years have basically given you a positive return, year in year out, with a few exceptions. Now, with two down years on the trot, private investors are waking up to what they have always wanted ' absolute returns.'
While some consider stockpicking or aggressive portfolios to be greater risk, Husselbee said that the industry is moving to an environment where these funds provide less risk of losing money but more risk not capturing the full upside in equities.
He said that in a rapidly rising market, most of these stockpickers will not see the full impact of the rise. However, they are also less likely to fall as far as the market on the downside.
According to Stoakley, the focused portfolios differ from stockpickers, such as Bolton and Schroders' own Denis Clough, in that they are even less benchmark aware.
Traditional stockpickers are aware of their benchmark indices to a degree and are more wedded to a particular investment style, whereas the new focus funds are just aiming for positive returns no matter what is in favour at the moment, Stoakley added.
In fact, Japan fund managers might be the example to follow as few would have greater experience at trying to achieve absolute returns in a bear market.
Martin Kemp, head of quants at Threadneedle, believes the more aggressive portfolios, rather than the traditional stockpickers, do offer greater risks to investors.
He said a long-only fund that is aiming for absolute returns is fine as long as it is in a time of a flat or rising market but he feels claims they can deliver in a falling market are a bit stretched. He said: 'Most stocks have links to others in the market. If the market as a whole is falling, then almost all stocks will be affected.
'An extremely focused fund will provide a very choppy rise. You are buying a manager's skill but if that skill doesn't materialise or the market is unkind in the short term, then there is scope for substantial underperformance.'
He also worries that there is an attempt in the market to equate these funds with hedge funds, when the risk profile on the two are different and the underlying assets are structured differently.
Simon King, co-manager of Gartmore's UK Focus fund and its UK long/short portfolio Alphagen Avior, uses the same investment mentality on his long-only fund as he does on the hedge fund.
Gartmore UK Focus, one of the few UK funds to have produced positive returns over the past year when the FTSE All-Share dropped 13%, is run as an extension of the hedge portfolio, with the long-only stocks featuring in both.
However, King added that UK Focus does keep an eye on the index so it is not a pure absolute return fund. With four sectors making up half of the FTSE 100, he said they are too big to ignore and it is dangerous not to pay some attention to what is happening in those sectors.
He said: 'We tend to look at stocks as how they will make us money, whereas when you think relatively you think how will this company do against the index. It is looking at holdings in pound terms rather than as percentage points.'
The stringent stop losses on the fund also add to this, he said. If a stock falls by 10% he sells it, full stop.
He said that if he was thinking on a relative basis he might hold onto the company believing market sentiment is holding it back relative to other companies or that 10% relative to a larger drop in the sector is exaggerating the movements.
The group has looked at ways in which UK Focus could add a shorting element to the portfolio, but King said due to FSA restrictions, the instruments available to unit trust managers are too inefficient to make much of a difference.
Managers can hold a certain amount in derivatives or futures, allowing for some amount of shorting ability but these are very small amounts and the processes are too manual, making the administration of them unwieldy.
The London Stock Exchange has plans to open up a covered warrants market later this year, which could increase both the liquidity of such instruments and the ability of long only managers to use hedging techniques in a unit trust.
Next week's news analysis will look at the performance of funds aiming at absolute returns.
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