While the growth of absolute return funds has ballooned in the last three years, their results so far may startle investors and their advisers
In three short years, absolute return funds have ballooned into a market worth an estimated e200bn. The majority of demand has come from continental European investors, ranging from small private clients through big banks to major insurance companies. UK investors have so far shown less appetite for these products.
A few absolute return funds now have three-year track records but most have been launched in the last two years and have a history of one complete calendar year at best. Some of the early results from an important group of funds - and the inferences we draw - may well startle investors and their advisers.
It is worth remembering when considering the results that investors in this type of fund are primarily concerned with immediate returns, usually expressed as a percentage above Euribor (cash). The asset classes on offer in these funds include standard equities and bonds, along with the derivatives now allowed by Ucits III. Some of the more exotic classes, such as weather-related bonds or carbon derivatives, are only to be found in hedge funds.
Importantly, given investor expectations of absolute return funds, it is clear from our research that there is no way to achieve cash-plus returns without extra risk and many, if not all, absolute return funds will fail to achieve their targets or even outperform cash in some years. That is, unless the targets are so low as to be not worth achieving.
The results for 2006 illustrate the point. We looked at Standard & Poor's Fund Services new absolute return sector, defined as funds that target cash-plus returns and that can go net short. We focused on the 60 euro-denominated funds only, since most of the demand has come from Europe. Of that total, 20 were launched in 2006 and did not have a full year's performance history.
Only 10 were launched before January 2004 and have over three years' history. Nearly all of the 40 funds with 12 months' history achieved positive absolute returns after fees in 2006, but only half of those actually returned more than Euribor. Where funds with a slightly longer track record were concerned, nearly all of them made a lower margin over Euribor in 2006 than in 2005.
There were various reasons why all these managers generated such disappointing returns in 2006. In general, they were subject to the workings of a couple of truisms:
• More ways to make money also means more ways to lose money.
• A fund manager who makes the wrong decision is unlikely to make money, whatever he invests in or whether he can go short or long.
More specifically, many existing absolute return funds are managed by fixed-income managers. This is for the historic reason that fixed-income managers have generally used derivatives more actively than equity managers over the last 10 years and therefore already have risk systems in place that can handle derivatives, as well as a greater appreciation of what can be done with them.
As a result, many fixed-income managers running absolute return funds invest almost entirely in the various fixed-income asset classes (including convertibles).
2006 was a difficult year for fixed-income managers as volatilities were low and many alpha sources did not generate profits.
Duration continued to be unpredictable as long-end yields fluctuated, even as central banks continued to tighten. It remained a struggle for managers to add value through duration positioning, although most added value from curve flattening trades in several currencies. Credit, a good source of returns for several years, did not add as much value as spreads had tightened so much.
Emerging market debt, on the other hand, followed up an exceptional 2005 with a shakeout in the second quarter of 2006. Some managers' risk limits forced them to reduce their positions as the market fell, so they failed to benefit from the subsequent bounce. Some chose to do so and some rode through the difficulty or increased their positions. Funds that can buy convertibles benefited from the strong equity market.
The very few absolute return funds that invest mainly in equities did better, on the whole, than fixed-income funds, as the market was easier to read. Multi-asset funds tended to struggle, partly because the long/short fixed-income portion had the same constraints as pure fixed-income absolute return funds and partly because tactical asset allocation decisions tended to be whipsawed by rapid changes of direction in market sentiment.
Against this background, individual results varied enormously. Standard & Poor's Fund Services' A/N3-rated Robeco Flex-O-Rente and Ecofi Prime de Risque both derive nearly all of their alpha from duration trading but Ecofi Prime de Risque has much higher risk limits.
It can be long or short about seven years duration, while Robeco Flex-O-Rente is about +/-4.5 years. In 2006, Ecofi made better and larger duration calls than Robeco and returned 17.5% against 2.6%.
Our research found that the level of risk a fund can take has been no guide to its return pattern. Credit Agricole and Fortis Investments each has a range of funds that uses similar investment processes with different risk levels. Fortis Absolute Return Stability outperformed Fortis Absolute Return Growth last year while Patrimoine CAAM VAR8 outperformed the less aggressive Patrimoine CAAM VAR2.
This has some parallels with single-strategy hedge funds, which also seek to achieve absolute returns. In this case, different hedge funds trading the same strategy can achieve very different results but there is also a wide dispersion of returns between the strategies. However, single-strategy hedge funds generally use more "niche" strategies and more leverage than the existing absolute return funds and so there is more variability in their returns.
Charges also affect net performance for investors, although funds often target returns before fees. We found a wide dispersion of management charges in our new absolute return sector ranging broadly from 50 basis points to 165 basis points, but sometimes with the additional factor of an incentive fee for the asset manager. This can mean that an investor would wind up paying an incentive for every percentage point the manager achieves above the hurdle rate, when the target level of absolute return held out is often above that level. Charging what the market will bear seems to be taking hold.
Overall, it should be no surprise that managers who make better decisions in one year achieve better returns. It would be unwise to conclude that managers who performed better in 2006 will perform better consistently or that managers who did poorly are incapable of delivering absolute returns. It is too soon to tell what will happen in 2007.
winners and losers
We will have a better chance to identify the winners and losers when we publish our overview of the absolute return sector in June. However, we would be surprised if at least some of 2006's underperformers were not back on track by then.
Investors are bound to concentrate almost exclusively on immediate past quantitative performance when looking at absolute return funds. However, our focus when assigning ratings to funds is longer term as well as incorporating an important qualitative element.
For example, although the absolute return managers had difficulty making their target returns last year, their investment and risk management processes mostly enabled them to achieve a positive return for the year, suggesting the processes are fundamentally well designed.
One year in which a fund misses its target need not necessarily lead to a fund rating downgrade, since we recognise that managers can make sub-optimal decisions from time to time, particularly in difficult markets. Therefore our process is not purely quantitative but seeks qualitatively to identify funds that we believe to be capable of attaining their objectives.
However, absolute return funds that fail to achieve their objectives consistently will undoubtedly not achieve a rating.
Note: All performances calculated in Euro's on a bid-bid basis, gross income re-invested.
Joined as head of strategy, multi asset, in June
Group income protection
Nine in 10 do not have income protection