Ucits III legislation has given a boost to the target return and absolute return funds market, says Henrietta Walker, senior investment research analyst at Old Broad Street Research, although, some managers are still trying to get to grips with these more complex offerings
Target return and absolute return offerings are becoming an important feature of the fund landscape - increasingly so, in fact, as providers get to grips with the new powers bestowed by the Ucits III legislation. As with any fund peer group, the mandates vary in nature and, although the return aspirations may look similar from one fund to another, the underlying investments can be very different.
Some funds are restricted to fixed income asset classes and cash, while others allocate assets to areas such as equities, property, other absolute return funds (including hedge funds), commodities and structured products. Of course, these various funds have different return and volatility expectations - particularly over shorter time periods - and this is important to bear in mind, especially if the underlying investor is very conservative.
Target return funds usually aim to exceed the return offered by Libor - the London Interbank Offered Rate, which is the rate banks offer each other for short-term deposits - plus a certain percentage on an annual basis. For example, many of the funds try to outperform Libor by 2% to 4% on a one-year basis.
Funds that have broader mandates may stop short of citing a specific target but would look to generate positive returns on a longer-term basis. Such funds tend to be Ucits III vehicles, which are permitted to use derivatives above and beyond the purposes of efficient portfolio management.
However, an important restriction is that the net asset value of the fund must always exceed the total derivative exposure and the underlying asset must be appropriate for the investment objective of the scheme.
The regulator is also strict about ensuring there are adequate risk management processes in place to monitor the exposure and we are seeing many fund companies developing their systems with this in mind. The increased flexibility in the use of derivatives means managers can now go short on a stock or an index, enabling them potentially to generate profit from a negative view.
The majority of target return funds currently available to retail investors are restricted to bond investments. As well as using cash actively, these funds will usually invest in all types of bonds, including gilts, investment grade corporate bonds, high-yield bonds, emerging market debt and derivative structures such as credit default swaps.
Within these asset classes, the fund managers may make duration calls - going short or long, depending on their views. Managers may also use derivatives to make a call on the shape of the yield curve - for example, by buying or selling futures to reflect their view that the yield curve may flatten or steepen.
Currencies may also be used as a source of alpha, with some of the more adventurous managers making out-and-out currency calls. While the framework of these funds is deliberately flexible, managers have strict risk parameters in place to ensure the scale of positions taken is controlled. Stop-losses are also sometimes used as part of this control.
Not all target return funds are purely bond-based, however, and one such example is the JP Morgan Cautious Total Return portfolio. This fund is invested in equities, bonds, convertibles and cash.
Although the fund has Ucits III powers, the manager emphasises asset allocation as the main driver of returns rather than the extensive use of derivatives. In other words, the manager will use derivatives to hedge currency exposure, gain optionality or hedge risk, rather than to increase returns.
Another offering, the Insight Diversified Target Return portfolio, is invested in a number of different investment types with the aim of achieving positive returns on an annual basis with the prospect of long-term capital growth. More specifically, the managers aim for equity-like returns over a full market cycle, to be delivered with bond-like volatility.
Investments include equity, bond and property funds, absolute return funds, commodity funds and structured products. Successful asset allocation is also the key source of returns for this fund. As indicated earlier, with their exposure to higher-risk asset classes, these offerings are likely to display greater volatility than bond-based funds and investors should be prepared for periods of negative returns, at least over shorter time periods.
Some funds are offered as target income vehicles. Such funds are run with the primary objective of achieving a specified yield that is superior to that available from deposits - usually together with some prospect of capital growth.
One of the most common structures is that of an actively managed equity portfolio with an out-of-the-money call option writing overlay. The premium received for writing the options is then used to boost the income of the portfolio. The strike price - and therefore the level at which the outperformance of the stocks is capped - will depend on the volatility of the market, but it generally tends to be about 10% above the current price of the share.
While these funds are obviously attractive to investors who require an income, it is important they fully understand the implications of capping the upside of equities. Again, this is a fairly new concept in the retail market and existing funds in this area have undergone some change to process since launch.
Finding their feet
A number of target return and absolute funds have been launched over the past 18 months or so and they may appeal to investors who are risk-averse - although it is still essential to understand the scope of the underlying investments to ascertain whether such funds are appropriate for the very conservative.
With this in mind, it is worth looking at fund performances during difficult market conditions to help determine whether they are appropriate for risk-intolerant investors. With the increasingly sophisticated use of derivatives we are now seeing, risk control processes are also very important to consider.
The powers available under Ucits III are still quite new to the retail world and it is fair to say many managers have been finding their feet in terms of running these more complex funds. With regard to performance, in general the track records are not long enough to make a fair judgement as to whether objectives have been achieved, but there is no doubt absolute return benchmarks can be very challenging - particularly so when we consider the net return after fees.
Of course, the real value or otherwise of these funds will be properly revealed if, or rather when, we encounter a sustained period of negative market returns.
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