Picking a winner
Given the strength of fixed income markets in recent years, there have been few stress periods over which to analyse a manager’s skill and/or willingness to short fixed income or to really understand their mind-set. Investors will have to work hard to understand how many ARB fund managers will react to stress periods or sustained bear fixed income markets. Few of the products available have existed through an entire business cycle and in recent years the best performers have been those that bought and held the riskiest assets.
Performance attribution analysis is an imperative aspect of manager selection, especially given their higher fees. Analysis by Standard Life Investments (SLI) shows the median absolute return fixed income manager’s returns are 90% correlated to credit markets.
“Their ability to deliver absolute return is therefore heavily dependent on the direction of credit spreads,” argues Alexander Gitnik, investment director, absolute return at SLI. “Given where we are in the credit cycle, credit will unlikely continue to provide the double- digit returns it has in the last few years. That begs the question of where the median fund will generate their alpha going forward.”
Several consultants and other market participants have questioned whether some products are effectively charging more for old ways of managing fixed income. “Investors need more clarity on how absolute return bond funds generate alpha,” bfinance’s Adaya says. “We have seen managers running these funds whose performance comes mostly from actively managing currency, for example. Investors need to be more wary of how these products are packaged and exactly how they make their money.”
Indeed, some commentators believe the term ‘absolute return’ is too widely used. ARB funds have not escaped the suggestion of a potential miss-selling scandal from some quarters and there is an expectation the regulator will at least provide firmer guidance in the future. “The regulator should look at historical positioning and attribution analysis to ensure these funds are not overly dominated by directional exposure to credit or interest rates,” according to SLI’s Gitnik. “There is concern about what is under the bonnet for many of these funds and whether they will be able to deliver if credit spreads move sideways or rates increase.”
Investors should head these warnings in their due diligence of ARB funds, but even before that point is reached, investors also need to be very clear about their objectives and exactly what the role of the strategy would be in their overall portfolio. This is crucial in being able to establish an appropriate and fair neutral point against which to measure performance. Greater understanding and the careful management of expectations are critical to avoid disappointment. Towers Watson’s Redmond warns: “It is critically important to understand why someone is going down the route of an absolute return bond fund, if at all. If the goals are reduced exposure to rising interest rates and returns with a low correlation to traditional investments, a diversified hedge fund portfolio likely represents a superior solution. Investors should start with a sceptical mind-set when assessing higher-fee absolute return vehicles, and at the very least understand if this fee premium is warranted. If investors believe interest rates are going up, there are likely to be superior ways to express that view that incurs almost no cost, for example modifying a liability hedge.
“That said,” Redmond adds, “for the right client, absolute return bond funds have merit, but they have to be very selective and really understand what they are buying and why. We have spent an inordinate amount of time looking at these products, but have identified few strategies that offer ‘value for money’ and as such have made very few recommendations to our clients.”
Where an investor’s expectations are both clear and reflected in the structure of the portfolio, and a manager is capable of delivering genuine fixed income absolute return, they are a good solution to the current secular shift. Sorting the wheat from the chaff is tricky to do and depends on the manager’s mindset.
As Sultan concludes: “It comes down to the experience and mentality of the manager. They need to be willing to put shorts on, sometimes in advance, and have protection in the portfolio with a view that it will help in a volatile period. These are the factors that differentiate the best absolute return bond managers.”
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