Absolute return is massively popular, but confusion over what is promised can lead to disappointment, finds Emma Cusworth.
“We will really find out who has been swimming without their trunks on as the tide is lowering in terms of the investment opportunity set.”
Dan Kemp
Absolute return has been one of the true buzz words of the last decade. As the term ‘hedge fund’ fell out of favour following poor performance during the financial crisis, absolute return became the common phrase for hedge fund strategies.
The space has since grown massively, both in terms of AUM and the range of products and strategies that are considered to fit under the absolute return moniker. With a change in tide for markets underfoot however, the space deserves a closer look, not just because the potential for returns comes under threat, but also because its broad scope has created an environment of confusion and disappointment.
Figures from Hedge Fund Research show assets have doubled since the financial crisis from $1.4trn in 2008 to $2.9trn at the end of the third quarter 2015. Fifteen years ago, in 2001, assets stood at $540bn – less than a fifth of today’s value. In the mutual fund space, the quintupling of assets has been even more rapid. The IA Targeted Absolute Return Sector has grown from 25 funds with a total of £12bn five years ago to 60 funds with £54bn by the end of Q3 2015. The biggest winners have been the large multi-strategy funds: Standard Life’s £26.7bn (as at 30 November 2015) Global Absolute Return Strategies fund, for example, accounts for over half the total £54bn assets in the sector.
GROWTH MASKS CONFUSION
However, the trend towards large multi- asset funds masks a growing problem for the absolute return sector – that of confusion and disappointment among investors.
As Dan Kemp, Morningstar’s chief investment officer, EMEA says: “It is clear from the European market that the trend towards multi-strategy funds indicates people are faced with confusion – they chose a broader fund that gives exposure to a large number of areas. Paralysis by analysis is a symptom of confusion.”
Absolute return is the one fund sector defined by outcome rather than asset exposure, which makes it particularly sensitive to confusion and disappointment. Furthermore, there is no clear industry-wide definition of what absolute return means and, therefore, what investors should expect from it.
Morningstar’s Kemp says: “Defining what is meant by absolute return has been a real problem for the industry over the last seven years. If someone defines it in terms of limiting short-term losses, that is not compatible with delivering long-term cash-plus returns. The challenge with absolute return funds as a category is that it tries to serve too many masters, which creates confusion and ultimately disappointment as funds will do one thing rather than both.”
DEFINING THE SECTOR
There is some broad agreement on what absolute return means – positive returns appears in almost all of them. The timeframe over which returns must be positive differs widely, however, from 12 months to a full economic cycle, while others suggest performance should be positive in all or most market conditions.
According to Caspar Rock, CIO at multi-manager solutions provider, Architas: “The majority of absolute return funds target positive performance in all market conditions, with low volatility and low sensitivity to traditional asset classes. While some may invest in income-producing assets, the strategies are not generally run to produce a regular income for investors. Downside protection is often a key feature, with the manager’s ability to short various markets providing the tools to reduce the impact of volatility.”
Sonja Uys, portfolio manager, alternatives, at Insight Investment, says absolute return funds should aim to deliver positive returns over a set period of time. It should focus on not losing money in that period and display low volatility along with low correlation to other asset classes. “True absolute return funds therefore tend to prove their worth in times of market turmoil,” she says.
Appropriate categorisation is an important factor of successful investment. UK equity funds, for example, are largely benchmarked against a big standard index and carry a similar level of risk to that index. Inherently they are fairly comparable, like horses racing around the same track.
“Absolute return is like letting all the animals in the zoo take part in the race,” Morningstar’s Kemp says. “The method and speed with which they get round will be very different.”
Or, as Principal Global Investors’ head of institutional business, Stephen Holt, puts it: “Absolute return strategies are highly reliant on manager skill, and the approaches taken will vary significantly between managers with no guarantee of success.”
Accordingly, looking in great detail at the individual managers is more important in the absolute return space than anywhere else. As Architas’ Rock states: “Given thebreadth of the universe and the varied interpretation of absolute returns, it’s important for investors to conduct their research and gain a good understanding of the expected return and volatility profile of prospective investments.”
SERVING TWO MASTERS
Being able to deliver positive returns in all (or most) market conditions means doing so when the market and other funds are down and when they are up. This requires significant skill and a small net exposure to markets.
Analysis of the Targeted Absolute Return sector by Barry Norris, CEO and manager of the Argonaut Absolute Return fund, shows only three absolute return funds are, in fact, delivering low correlation to traditional assets with negative correlation to the European stock market, and those funds tend to perform poorly. By contrast, over half of the funds in the sector have a correlation of over 0.5 with the European stock market, which suggests limited diversification benefits. Only two funds appear to combine an attractive return profile with a low correlation to the European stock market.
The absolute return space as a whole typically exhibits a positive correlation to equity and bond markets, according to Morningstar’s Kemp. “They have enjoyed a tailwind of rising equity and bond prices, but if we move to a scenario where real interest rates started to rise, then that would be a challenging environment for equities and bonds,” he says.
On the other hand, if a fund were to serve the other master, as Kemp describes it, and provide long-term cash-plus returns, the low correlation and downside protection creates a significant drag on performance. This explains why many unlevered absolute return strategies tend to have relatively low return targets (such as cash plus 2-4%, for example).
PGI’s Holt says: “Over the credit cycle, absolute return strategies should lag an approach that is less constrained by the need for capital protection.”
Analysis of 12-month returns for all share classes for EU domiciled UCITS funds in the Alt Morningstar Categories, however, shows that even these low return targets are difficult to achieve. Only 10.6% of share classes provided a yield greater than zero, with the rest posting zero yield. The average yield overall was a mere 0.2% and even among those that did achieve a positive return, the average yield was only 1.85%.
Meanwhile, the HFRI Fund Weighted Composite index posted a decline of -0.85% percent in December, giving it a full-year performance of -0.85%.
It appears the majority of absolute return funds have therefore failed to serve even one master in the recent past, and fewer still are serving both successfully by providing cash-plus returns and limiting shortterm downside losses.
THERE MAY BE TROUBLE AHEAD
Demonstrating the ability to deliver on a promise is important for absolute return funds, however. Lack of a clear definition arguably means investors seek the comfort of a track record even more than they might for other sectors, but, as Richard Philbin, CIO of Wellian Investment Solutions points out, just because a fund has delivered an investor’s desired outcome in the past doesn’t mean it is going to do so in the future.
Capital markets have been driven by falling real yields over the last 25 years, which meant bonds didn’t create too much of a drag when equities were doing well. Since the 1970s there has not been a sustained environment of falling equity and bond markets, which tends to happen in a tightening environment, although glimpses were seen during the Taper Tantrum in 2013 and also in 2004.
If markets move into a scenario of rising real yields, which the Federal Reserve expectations suggest will be the case, the market for equities and bonds will potentially be weaker and that could feed through into weaker returns from absolute return funds. Compared to prior interest rate cycles, this is also the weakest ever growth and inflation backdrop in which central banks have started raising rates.
Investors therefore need to be aware the environment for absolute return funds may become more challenging.
As Morningstar’s Kemp warns: “We will really find out who has been swimming without their trunks on as the tide is lowering in terms of the investment opportunity set.”
And then there is the question of fees, which, in the context of the low returns being targeted and the smaller opportunity set, will have a greater impact going forward. Argonaut’s analysis across the Targeted Return sector, for example, suggests approximately one quarter of funds have an annual management charge of at least half their standard deviation.
“This implies that even in a good year fees will eat away at least half of the implied return,” according to Norris. “This begs the question as to whether low-volatility Targeted Absolute Return products offer value for money as their fees would seem to consume an unhealthy proportion of the targeted return.”
A NEW DAY, A NEW MONIKER?
Interestingly, just as the term ‘hedge fund’ fell out of favour, so ‘absolute return’ appears to be going out of fashion. Many managers are keen to distance themselves from the moniker, especially given the widely-understood definition (and therefore expectation) of consistent positive returns.
Cardano’s CIO, Keith Guthrie, believes this is because the term absolute return can be interpreted as “never being negative rather than an objective to target a certain level of return with risk that the returns could be negative”. “People are trying to find the right words to encompass the concept,” he says. “Many are using targeted returns.”
Managers are also moving away from the notion of downside protection, focusing instead on the diversification benefits provided by the funds.
As Michael Ho, a senior managing director of State Street Global Advisors says: “Post 2008, many hedge fund providers claimed to provide absolute returns, but that is not the case any more. They want to be seen more as diversifiers.”
For an industry that generally hates talking in absolutes, it is perhaps unsurprising that so many managers are trying to move away from the absolute return moniker towards something that would naturally lower investors’ expectations. With tough times ahead, the need to avoid confusion and disappointment becomes paramount. Importantly, the underlying strategies being employed remain the same, albeit they are adopting more appropriate titles that align better with the objectives they are likely to achieve.
That said, Rock stresses the importance of assessing each investment individually, rather than getting caught up in “the classification lingo” as, he says: “managers will align themselves to whatever the classification du jour is.”
