Even if they do defend capital over the longer term, not all absolute return funds have a good record of avoiding high drawdowns, warns Sam Liddle - something advisers should bear in mind when considering the sector
Until last month, drawdowns seemed almost to have become a thing of the past. Equity markets had risen, largely uninterrupted, since March 2009, while the UK gilt yield had dropped steadily over the same period - or even arguably since the early 1980s. Volatility had been hitting rock bottom. Apparently all people had to do to see their capital grow was be invested. Easy.
Notwithstanding February's bout of market volatility, there is an argument this ‘easy life' could continue. The economic environment is benign. The IMF has recently upgraded global growth, with US tax cuts and Chinese economic growth continuing to drive the world economy higher. Inflation - for the time being at least - appears to be under control. There are plenty of reasons to believe financial market strength could be sustained.
Still, there is the important question of what happens if it does not. Volatility is increasing in bond markets. The 10-year treasury has moved from around 2% in September to a peak of 2.95% at the end of February. Equity valuations look high, particularly in certain sectors. The prospect of rising inflation and/or interest rates could derail the status quo. The strength in equity and bond markets has largely been driven by central banks pumping money into the financial system. This is starting to reverse.
There are also wider considerations. To what extent will technology disrupt the current economic and political order, for example? What role will geopolitical concerns play from here? Will Jeremy Corbyn get into Number 10?
In this context, investors need to consider the potential for drawdowns in their investment. While long-term investors have time to wait out the volatility, it does not mean shorter-term losses cannot take their toll. The greater the amount lost, the higher the gain required to break even. While a 10% loss in any one year would require an 11% gain to break even, a 30% loss requires a rise of 43% to break even. In other words, even relatively short-term losses can have a lasting impact on long-term returns.
For pension portfolios, the consequences of short-term loses can be even more profound. While there is an increasingly recognition investors need to use risk assets well into retirement, that is not the same as exposing a portfolio to the full force of equity market drawdowns. In particular, drawdowns early in retirement can have a profound effect.
Research by insurer Aegon showed how important any early losses can be by looking at historic returns. It took a retiree with a drawdown pot of £225,000, taking the equivalent annuity income of £13,600 each year and calculated how the stockmarket would impact their money over the next decade.
It found that if that person had invested in January 1995, just ahead of a buoyant period of stockmarket returns, they would have a pension worth £269,219 at the end of the period. Compare that, however, to someone who invested at the start of January 2000 - they would end up with just £114,303 10 years later.
This argues for those retiring today to exercise some caution. If markets are near the top of their historic range, it may be just the sort of time where investors would end up in the second scenario, rather than the first one.
Absolute return funds would seem a natural choice to solve this problem and yet not all of them have a good track record of avoiding high drawdowns - even if they do defend capital over the longer term. The average maximum drawdown for a long/short equity fund, for example, is -11.08% (Source: Citywire, Alternative UCITS Long/short equity sector). Some will only seek to provide an absolute return over rolling three-year periods and volatility in the interim can be significant.
Avoiding losses or preserving capital should be the vital feature of any fund that claims to be ‘absolute return' in nature. There are a number of ways to do this but we start with cash as a benchmark and only invest where we see real opportunities for an asset to deliver a positive, risk-adjusted return.
In practice, this means monitoring a range of assets and securities at all times, setting alerts when they reach a price we see as attractive. We have a target valuation at each side, which might be a spread over gilts for corporate bonds or a target stock price for equities. We buy all securities with a stop loss, so we know our maximum downside. We also have a trailing profit stop, which can prevent us getting ‘carried away' with a good idea.
Floating rate notes currently make up around a third of the Tenax Absolute Return fund and the reasons behind this are simple. They provide a hedge against rising interest rates while offering holders protection. They differ from other fixed income securities by having a variable coupon rate reset every quarter to a specified level over the reference rate, such as LIBOR. Thus, when interest rates rise, LIBOR in turn ratchets up and the coupons on floating rate notes increase.
In the rest of our fixed interest allocation, we maintain a portfolio with high-quality, senior, secured debt at the short end of the duration range. Equities, although currently a small part of the allocation (8%) are invested in blue chip names, at attractive fundamental valuations with strong management teams and track records with high barriers to entry.
As we see it, managing volatility is important for investors in an absolute return fund. If they were comfortable with volatility, they would simply invest in a long-only equity fund. Absolute return funds should solve the problem of drawdowns, but many do not. People in retirement often do not have the chance to recover from falls in their assets and cannot re-earn their wealth. As such, advisers would do well to check a fund's record on drawdowns ahead of any investment.
Sam Liddle is sales director at Church House Investment Management
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