The youthful absolute returns sector has had a meteoric rise in popularity, but what does absolute return actually mean?
Absolute return is the buzz word of the past few years and the attention given to this strategy is growing rapidly. The IMA’s Absolute Return sector was launched just 18 months ago with 12 funds, only five of which were domiciled in the UK and just three providers were well known retail investment houses. Today there are 30 constituents in this peer group, the majority of which are based onshore and run by well-recognised retail groups.
Considering this strategy is new to retail investors, although it has been available to institutional investors for many years, the question arises as to what absolute return actually means. It is as literal as the name implies. These funds aim to produce an absolute return on your investment, regardless of market conditions. They are not to be confused with what some groups call ‘total return’ funds and are a world away from those managed on a ‘relative return’ basis.
A fund managed on a relative basis does not mean ‘quasi-tracking,’ nor does it imply that a manager running such a portfolio is not attempting to achieve an absolute return. There was and still are those maverick fund managers which construct their portfolios with little regard for the index. But as their funds are still compared on a performance level to a benchmark, they still fall under the relative banner. Changing rules and regulations from the FSA now means advisers can select managers who not only veer away from the index but construct their portfolios using hedge fund-like techniques such as shorting to make gains no matter the market conditions. It is this where absolute return funds come in.
Total return funds, sometimes referred to as ‘targeted return’ are the precursor to absolute return strategies. Often these portfolios feature a stated goal or aim to achieve a certain return over a set benchmark over a specified timeframe. But a total return fund does not aim to always make a gain. In fact many can achieve their goals and still post a loss. Total is simply refers to the capital gain (or loss) plus the income. If, for example, a fund makes £50 in income from dividends but loses £100 in its capital value then the investor would end up with less than they originally invested, yet the fund would have done better than the index.
Absolute return (AR) on the other hand simply aims to produce just that, a gain. Its goal is not to beat a benchmark but simply to always make a gain. A key differentiation between AR and total and/relative return funds is the methods used by the fund managers. Not only are index constituents ignored in the stock selection of an absolute return fund but the managers of these portfolios employ techniques historically only seen in hedge funds. Although the techniques may be similar to a hedge fund, it is worth remembering they are not the same level of risk as a hedged vehicle. Under FSA rules a Ucits III fund may go ‘short’ a stock but only synthetically, using derivatives. A hedge fund goes short using the physical stock, borrowing and then selling the holding with the hopes it will fall in value so the manager can then buy it back at a later date when it is cheaper.
While AR funds may have a goal of obtaining a gain throughout the various market conditions, not all will be successful in this aim. The term absolute refers to the intention and is not a guarantee. And as with any portfolio in any sector, there are some that will achieve their stated goals better than others. Advisers can not look at these funds as one uniform group, not the least of which because the strategies employed by the fund managers trying to achieve returns can all vary significantly. Some AR funds are the equivalent of a long/short hedge fund strategy while others are labelled market neutral.
This puts greater pressure on advisers to understand what the fund manager is doing in the fund and manage client expectations, John Clougherty, head of retail at Aviva Investors, said. “Advice in this area is key as there are many nuances and variance in risk profiles. IFAs need to look at the experience and track record of the fund manager and understand the philosophy and process of the fund. For example, our fund is likely lower risk than others in this sector. We have designed our fund to deliver steady, incremental returns through all types of market conditions, whereas others are more aggressive in their approach.”
Although absolute return funds are increasing in both popularity and importance for advisers, relative return still has a fundamental role for investors. Absolute return strategies are not meant to replace the traditional investment fund, but instead to offer an alternative or an enhancement to a client’s overall portfolio.
Portfolios run by active managers can make some huge returns during bull markets, whereasAR will likely underperform. Just as the opposite can be true when market conditions are reversed, with active, relative funds sitting on losses while AR funds post small gains. This was seen in the difficult 2008 period followed by the more buoyant 2009. Over 2008 the average performance for the IMA’s Absolute Return sector was -1.8%, the worst performer falling 7.8%. In comparison there was not a single portfolio in the UK All Companies sector that did better than a -11% return. Over 2008 the average fund in the UK All Companies sector lost 32%, which on a relative basis was an underperformance of the FTSE 100, which fell by 31%.
This year has been much better for fund managers and this is reflected in the gains seen, particularly those funds with a growth mandate. This Year to 28 October the average UK All Companies fund has risen by more than 26%, with the top performer achieving a gain of 109%, according to Trustnet’s figures. Year to date AR funds have posted a much loweraverage gain of 10%.
Clougherty noted achieving high gains is not the point of AR funds and believes its role in client portfolios will only grow over time. AR is not just a ‘me too’ marketing gimmick but has a real function for clients, adding value through the provision of consistent, smooth returns, he added.
