Sam Liddle shares with Professional Adviser readers why it is important not to take the Absolute Return sector at face value
Absolute return funds seem to attract criticism on a cyclical basis, usually annually. This year is no exception with some commentators recently declaring that the strategies are failing to deliver on their promise of “strong returns with low risk”. Some are even predicting a ‘blood bath’ for absolute return funds should recession hit.
It’s all meaty stuff of course and makes for an entertaining read, but how true or fair are these claims? To take a view on a sector based on an average of overall performance or sentiment towards it is to not see the trees for the wood. The Targeted AR sector is complex and often misunderstood. For example, the 50 largest funds in the sector follow in the region of 38 different benchmarks, making comparisons largely impossible and often irrelevant.
With markets having been volatile in recent years, things have got interesting for absolute return funds trying to adhere to their stated objectives. Importantly, it has allowed the market to see who has the most risk on the table. In a volatile environment, the pursuit of growth while disregarding capital preservation seems like a reckless strategy.
Some assets look uniquely vulnerable. Portfolio managers and investors should be focusing their attention on absolute return funds aiming to protect them in difficult market conditions. After all, isn’t that the purpose of absolute return?
What is Absolute Return anyway?
Absolute return must mean just that. To our mind, an absolute return fund should have a number of key characteristics. First, it should start with cash: every investment beyond cash should offer a compelling reward potential for an appropriate level of risk. If, in volatile and uncertain market conditions, there are relatively few opportunities that meet those criteria, holding higher weights in cash or near-cash instruments seems sensible. Investing on an absolute return basis should mean ensuring every investment is made with an awareness of the downside risk. Many funds adopt a ‘rolling 3-year’ absolute return target, leaving investors to suffer significant volatility in the interim. There is always the danger that having waited three years, investors don’t get the absolute return they wanted either but it’s too late by then.
Instead, we continue to target a positive return over rolling 12-month periods, as we have since the Church House Tenax Absolute Return Strategies Fund was launched in 2007. To us, every investment beyond cash should offer a compelling reward potential for an appropriate level of risk. If it doesn’t, we will hold cash or near-cash instruments, such as Floating Rate Notes.
Quantitative easing has, until recently, encouraged investors to invest in higher risk strategies, reaping the rewards while not having to take the pain. Recent volatility in markets has begun to expose this. Investors will need to be more careful about how they preserve the value of their wealth in future. Capital preservation should be viewed as a ‘must have’ and any return over cash a ‘nice to have.’
Standard equity and bond funds can ride market highs and lows and can claim to have done their job if they lose less than the market. This is not a claim that can reasonably be made with an absolute return fund.
This is important because of the impact significant drawdowns can have on long-term returns. 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. Avoiding these losses is a vitally important feature of any fund that claims to be ‘absolute return’ in nature.
It is important to understand the maximum downside of any position. In the recent market volatility, it is clear that a number of absolute return funds have not been run with these risk measures in place.
Beware the bond bubble?
The extraordinary rally in bond markets in recent weeks has generally been taken as a sign that a recession is at hand with an estimated $15 trillion being held in negative-yielding bonds. If this is the case, then this is exactly the time when investors need an absolute return fund with the prevailing objective of capital preservation.
In looking at absolute return funds, fund selectors should look for a history of low volatility, low beta against equities in falling markets and a reasonable long-term annualised return (5% in the case of Tenax), rather than whether the fund is long-only multi-asset as opposed to a hedge strategy.
Absolute return funds potentially have an important role to play in decumulation portfolios as part of the new pension rules. A genuine absolute return fund should be able to deliver reliable, low-volatility returns, so that retirees can take regular withdrawals from the total return and preserve, or even grow their capital over time. However, they cannot fulfil this role if they are experiencing significant market directionality or drawdowns at any one time.
We believe some of the criticism directed at absolute return investing in recent months tars all funds with the same brush. There are funds that protected capital during the recent market volatility, and even used the volatility to their advantage. Investors just have to pick with discernment.
Sam Liddle is the Sales Director at Church House Investment Management working with professional fund buyers. The above piece was written for such professionals including financial advisers and wealth managers. It has also been published by Professional Adviser Magazine.