Against the backdrop of the credit crunch, absolute return funds have come the fore, but the investment strategies used are not a new phenomenon and have been around for six decades
After a year in which virtually all the major asset classes posted heavy losses, investors are now increasingly looking at alternative investment strategies.
Since the start of the credit crunch, global equities have fallen by more than 40%, corporate bonds and commercial property are in negative territory and even cash has left savers nervous.
Against this backdrop, absolute return funds have really come to the fore as investors have started to look further afield for products capable of delivering steady returns while aiming to provide a refuge from such extreme volatility.
But the hype around this 'new breed' of fund overlooks the fact these products are actually using investment strategies which have been proven over several decades.
AW Jones & Co, the world's first absolute return fund, launched back in 1949 and is still running. It may have been a different era then, but the eponymous Alfred W Jones, an accomplished statistician, recognised then, as now, that by simultaneously buying stocks and selling others short, he could manage out market risk and actually reduce the overall volatility of the portfolio.
Both Jones and his investment process went virtually unnoticed for over 15 years until 1966 when Fortune magazine highlighted the fact he had outperformed the top mutual fund by 87% over the past decade. This sparked a flurry of interest and was the precursor to such modern day luminaries as George Soros and Michael Steinhardt entering the market.
Absolute return strategies largely remained the preserve of super-rich clients even after Yale University became the first institutional investor to recognise them as an individual asset class in 1990.
The Ivy League university has long been a trailblazer in the field of multi-asset investing and was the first pension fund to back private equity and venture capital back in the 1970s.
Even with this powerful endorsement, UK institutions lagged behind their US peers and the near constant upward trajectory of the markets throughout the 1990s left far too many only recognising the benefits of diversifying away from the traditional asset classes after they had been bitten.
The bursting of the technology bubble in 2000 and ensuing three-year bear market convinced many institutions of the benefits of moving away from the conventional approach to running managed mandates, leading them to increasingly incorporate alternatives into their asset mix. The recent impact of falling asset values has only served to reinforce this message.
Until recently, however, it has been very difficult for individual private investors to build this additional layer of diversification into their portfolios as the wider retail market has had very limited access to alternatives. The advent of Ucits III in 2002 was a huge breakthrough, effectively democratising these investment strategies by opening them up to retail investors. The first wave of absolute return funds launched in 2005, such as the BlackRock UK Absolute Alpha fund, was something of a slowburner as groups soft-launched in order to build up their track records.
At the time, stock markets were rocketing and investors chased returns, resulting in large inflows into long-only strategies. With new powerhouse economies surging forward, downside risk was way off most people's radars. The onset of the credit crunch changed all of this. As investors started to feel the pain of being far too heavily skewed towards long-only equities, the appeal of funds with a low correlation and the ability to generate consistent growth became more obvious.
The inflows into the BlackRock UK Absolute Alpha Fund are a case in point. The fund took in over £1bn between June 2007 and June 2008, swelling in size from £200m to £1.2bn - remarkable when you consider the economic backdrop.
Since then, the Investment Management Association has established a new sector for absolute return funds and over the course of 2008 it attracted a mammoth £1.3bn of the industry's £3.3bn net retail sales last year.
Following a recent spate of launches, there are now 23 funds in this fledgling sector offering a diverse range of investment strategies. The timing of these launches inevitably raises concerns that asset managers are merely attempting to benefit from the latest investment fad, particularly given the prevailing market conditions and the time that has lapsed since the Ucits III legislation was passed.
The truth is rather more dull, however. Absolute return funds have low barriers to entry but high barriers to success. This has been proven by the mixed performance within the sector. In order to select the right fund, advisers have to ask the right questions of the manager. Do they have a demonstrable track record of running long/short mandates? Do they have experience of running absolute-return strategies in both rising and falling markets? And, do they have the ability to blend short-term tactical trades with longer-term themes, or they are stuck in the traditional mind-set of delivering index-plus returns?
The ability to use derivative instruments within a portfolio in order to reduce risk offers fantastic opportunities to enhance returns. But ensuring you have the right risk overlay and effective operational and risk management systems in place to support that is vital.
The industry is duty-bound to provide educational support to inform advisers how these products work so they have the confidence to recommend them to clients.
Much of this centres upon clients' perceptions of absolute return funds and managing their expectations. They are not guaranteed products, so if investors cannot tolerate any drawdowns these are not the solutions for them.
In the 34 years that Alfred W Jones personally managed AW Jones & Co, the fund had three down years, but this compared with nine years of negative returns from the S&P 500 Index.
By his own admission, he would not be at the top of the charts in a rampant bull market. What he was able to prove, however, was that by participating in much of the upside and protecting on the downside, he would significantly outperform over the length of an investment cycle. Moreover, by holding his fund in a diversified portfolio, it would actually reduce volatility through its non-correlated approach.
One danger in the current climate is that investors see absolute return funds purely as a way of making money or protecting their capital in a downturn. Some may treat them simply as an attractive place to park their money and generate absolute returns while they wait until recovery is in sight.
The perils of this boom-and-bust approach are all too familiar. In contrast, a core holding of quality absolute return funds could potentially generate a stable source of non-correlated returns throughout the market cycles, around which higher volatility, long-only funds can be added.
Like absolute return funds themselves, this is hardly a 'new-fangled' approach, but these investment strategies should now be forming a cornerstone of portfolio construction.IFAonline
Caring for children and elderly relatives
Similar to June 2007
Square Mile’s series of informal interviews
Fine reduced to £60,000
Two roles created