Absolute return funds should fulfil a specific role in a portfolio, argues Sam Liddle - and nobody expects or wants their goalkeeper rushing up the pitch to try and score
The question of exactly what constitutes ‘absolute return' taxes fund managers and investors in the sector alike. It is clear it means very different things to those who manage absolute return funds and, as such, it is perhaps no wonder investors are confused.
To our mind, the sector definition is inadequate. ‘Funds managed with the aim of delivering positive returns in any market conditions' is simply a statement of intent - it does not hold fund managers to any specific parameters, risk limits or performance targets.
Even this ‘intent' is problematic. It could reasonably be assumed that an absolute return fund manager would strive for, well, an absolute return - but then it turns out that defining what that means is more difficult than it initially appears.
The first point of disagreement is the benchmark. Research by Harwood Capital shows the 50 largest funds in the sector compare themselves to 38 separate benchmarks.
Some simply aim for Libor plus a couple of percent, some for Libor plus quite a lot. Others have composite benchmarks, while some have different definitions of cash. The point can seem pedantic, but it influences the risks fund managers take and may lead to quite different investment outcomes.
A further subject of disagreement is the length of time over which the aforementioned absolute return should be achieved.
Initially, most absolute return managers considered a year was an appropriate time period. But this proved increasingly difficult in the wake of the financial crisis and the aggressive monetary easing that followed. A number tacitly changed their benchmark to three years or, even more nebulously, ‘a business cycle'.
Our view is that absolute return should be a permanent target, rather than hoping the cyclicality of markets will bail us out. As such, we believe a target of an absolute return over a rolling 12-month period is appropriate and moving the goalposts is not an option.
The level of volatility in an absolute return fund is also a point of contention. Here, our view is that investors buy absolute return funds to lower overall portfolio volatility, but this is not a view held universally in the sector.
There are a handful of funds in the sector with three-year volatility levels from 11 to 13 and fairly diverse returns (many negative). This level of volatility is comparable to several funds across the European Smaller Companies, UK Mid Cap and Global Equity Income sectors. The point is that there are some funds in the sector taking equity-like risk, without delivering equity-like performance.
If fund managers are taking this level of risk, investors might reasonably expect them to be using it wisely, but there are a number of funds within the sector that have experienced significant drawdowns. In 2016 - a year in which, let's not forget, the MSCI World index rose 4% in US dollar terms - four funds experienced double-digit losses.
Absolute return funds should be protective. It is clear many investors erroneously assume the term confers some kind of guarantee. While this is clearly not the case, and better education is needed, consumers should be able to trust their absolute return fund managers has preservation of capital as a clear and explicit aim. According to the Wisdom Council's panel of investors, the starting point for many is to compare any investment to a cash equivalent.
Part of this does require a different approach on the part of investors, who have grown used to picking funds on strong past performance. In the absolute return sector, investors should be just as nervous about funds that have delivered 15% or 20% upside as those showing a 10%-plus downside.
It suggests a manager is taking far too much risk. Sometimes they may be successful but, the next year, they may not. If investors want this level of risk, why not simply choose an equity fund? Drawdowns need to form an important part of the analysis of absolute return funds.
Absolute return fund managers also take a differing view on the simplicity with which they achieve their returns. Simplicity is important. While they do not feature in our portfolios, we would not argue derivatives should not be used - after all, they were developed to limit risk.
That said, there is a significant difference between a standard future and some of the exotic instruments being used in absolute return funds. Once again, investors need to be able to understand what they are buying and many do not.
Absolute return funds should fulfil a specific role in a portfolio. A useful analogy is that of a football team, with absolute return funds comparable to a goalkeeper - they are an integral part of the team, in terms of defence and preservation, but investors should not judge them on the number of goals they score. Equally, investors do not want their goalkeeper distracted by trying to score goals, when they should be defending the goal.
Of course, there are ‘tricky' funds in every sector. The problem is that the absolute return fund grouping is still a nascent sector and has to earn its place in portfolios. The overall image of the sector has been tarnished by managers that, to our mind, are not fulfilling the brief, while at the same time still meeting the very loose Investment Association sector definition.
Investors in the sector - and their advisers - should be looking carefully at a manager's historic performance, drawdown, volatility and the type of risks they are taking. Otherwise they risk buying a striker, while leaving their goal wide open.
Sam Liddle is sales director at Church House Investment Management
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