The IA Targeted Absolute Return sector continues to take a bashing. The unfortunate effect of this is that we are all prone to making blanket assumptions, even in an industry where scrutiny and in-depth research is not just preferred, it is required. Sometimes though, it pays to look beyond the headlines.
In some cases, the criticism is clearly justified but in others, it is not so clear cut. The truth, as we are all well aware, is that the sector is rather convoluted and clouded in its make-up.
Many funds call themselves ‘absolute return’ yet their characteristics often appear to contradict this. Some in the sector have lost their way in a bid to counter volatile markets; others have been fighting against the long-term low interest rate environment, but we would take issue with the idea that the concept of absolute return is somehow flawed.
On the contrary: done well, absolute return investing (certainly those sticking to the original concept) is in tune with the way most people want to invest. They want consistent, predictable returns, compounded over time, where the capital value is not subject to large drawdowns.
In particular, it chimes with the new pensions’ landscape that will see far fewer people annuitise, and many hold risk assets long into retirement with a need to draw income from their investments, while maintaining capital.
Clearly not all absolute funds are flawed but in determining which will meet investors’ aspirations over the long term, we believe the fund managers should be able to answer several core questions:
Is cash really king?
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.
What is the maximum drawdown?
Investors need to consider the potential for drawdowns in their investment. While long-term investors have time to wait out volatility in financial markets, it does not mean shorter-term losses cannot have an impact. 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.
Absolute return funds would seem a natural choice to solve this problem. However, not all of them have a good track record of avoiding high drawdowns, even if they defend capital over the longer term. Maximum drawdown in the IA Targeted Absolute Return sector ranges from -0.2% to -10% over just one year to -1.8% to -12% over three years.
Avoiding losses, or preserving capital is 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, only investing elsewhere when we see real opportunities for an asset to deliver a positive, risk-adjusted return.
In practice, this means monitoring a range of assets/securities at all times, setting alerts when they fall to a price we see as attractive. This might be a spread over gilts for corporate bonds or a target stock price for equities.
In the absolute return sector, investors should be just as nervous about funds that have delivered a 15%-20% upside as those showing a 10% or more downside. It suggests that 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.
How do you measure performance?
Some 50 of the largest funds in the IA Targeted AR sector have 38 separate benchmarks between them. This makes comparisons largely irrelevant. Some funds simply aim for Libor, 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 for clients believing absolute return will smooth returns and mitigate losses.
Also, a subject of disagreement is the length of time over which that absolute return should be achieved. Initially, most absolute return managers considered that a year was an appropriate time period. But this proved increasingly difficult in the wake of the Global Financial Crisis and the aggressive monetary easing that followed.
A number of managers tacitly changed their benchmark to three years or, even more nebulous, ‘a business cycle’, potentially leaving investors to suffer significant volatility in the interim. There is always the danger that having waited three years, investors do not get the absolute return they wanted either but it is too late by then.
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 achieving an absolute return over a rolling twelve-month period is appropriate. Moving the goalposts is not an option.
What is at the core of the fund manager’s objective?
Capital preservation, rather than ‘cash plus,’ should be at the heart of any absolute return fund. In a bull market, investors do not need to be particularly smart about the way they invest to preserve the capital value of their investments. In this environment, a straightforward 60/40 equity/bond split would preserve capital and give investors some growth to boot.
After years of quantitative easing, things are changing and investors are unlikely to find the environment so forgiving. This could present problems because many investors have been drawn higher and higher up the risk scale in search of income and/or growth.
Those who would normally be in government bonds have moved into corporate bonds, and then into high yield bonds, and bond (usually income-seeking) investors have moved into higher yielding equities and so on.
This phenomenon has also been seen in absolute return funds. You do not have to search the news too hard to find recent reports warning some absolute return funds have been taking too much risk, and therefore potentially subjecting investors to major and unexpected losses.
Some absolute return strategies can be opaque and it can be difficult to see the risks without really looking under the bonnet. The steady march higher of financial markets has flattered funds and has left their risk measures untested.
The pursuit of growth while disregarding capital preservation seems like a reckless strategy. Some assets look uniquely vulnerable in certain environments and investors have to ensure that their absolute return fund is going to protect them in all market conditions, not just the benign ones. They should not be seduced by low volatility into thinking that capital preservation is easy.
This article first appeared in Investment Week online.