Formula-defined risk and returns – without active management risk
The first 10 years of the 21st century may be remembered as “the decade of asset bubbles”. First, we saw the technology and internet bubble, with many investors losing more than half of their invested capital. Then we saw housing, commodities, complex CDOs and leveraged buy-out loans all of which were created by excessive leverage.
Further, twice in 10 years, investors lost money over a five-year investment period, while also grappling with the dilemma of increased stock market volatility and low interest rates. The credit crunch and collapse of Lehman Brothers in 2008 stoked investors’ fears and heightened their propensity to seek investments that promise the return of their capital in addition to returns on their capital.
The absolute return answer
One answer put forward by the investment industry is absolute return funds – which take advantage of the more relaxed regime in using derivatives and other investment techniques under Ucits III.
Many investors see absolute return funds as the answer to their need for returns without the volatility – or at least with a significantly lower volatility. According to IMA, as at the end of November 2009, the total outstanding assets under management for absolute return funds exceeded £8.8bn – and it was the best-selling IMA fund sector in terms of net retail sales in Q2 and Q3 in 2008, when stock market volatility reached record levels, as the credit crisis reached its peak.
When the IMA launched the absolute return fund sector, it included funds that are ‘managed with the aim of delivering absolute – that is more than zero – returns in any market conditions’. It stated in a footnote a positive return is expected to be delivered every 12-month period. However, it only takes a cursory glance at the sector to see the performance of absolute return funds is highly variable.
Performance of absolute return funds
The table shows the performance of some of the best-selling UK absolute return funds. Over 2009 it ranged from 14.77% to an unimpressive 0.65% – and at any point during the year the divergence of returns was far more dramatic between best and worst. It is no wonder the IMA also included a footnote on its press release when it launched the absolute return fund sector: “Performance comparisons are inappropriate due to the diverse nature of the objectives of the funds populating this sector, including different benchmarks, risk characteristics and timeframes for delivering performance”.
The fact is performance variations highlight the variation in strategies employed by managers – but also their skills and abilities to run these strategies consistently. No wonder some cynics question the motives of why these funds use risk-free rates, usually Libor, as their performance benchmark – which are also the triggers for their performance fees.
All funds have the ability to short an investment through the use of derivatives, such as exchange options, futures and CFDs. Some funds use the ability to short to take a strong market, running ‘naked short’ positions on stocks, whereas others always match or ‘pair’ a short position with a long position, usually in the same sector. Some funds are run like ‘free-style’ funds, using multi-asset classes, while others are focused on controlling risk with market-neutral strategies. As should be obvious, the resultant risk of these strategies varies as much as their performance.
Of concern to many is the ability of long-only managers taking on management of AR funds, especially since managing short positions is a very different game. Hedge fund analysts are all too familiar with the fact even managers who can identify the right stocks to short often lack the trading acumen to execute such strategies successfully, particularly in timing the exit of the short positions.
It is irrefutable the absolute return concept is the holy grail for investors. But, the key challenge for advisers and investors is selecting managers who genuinely know how to utilise the relaxed constraints and more flexible investment techniques allowed, in different investment environments and throughout entire market cycles. Consistency of returns under different market conditions is the raison d’etre for these funds – yet the performance statistics indicate the jury is still out on this critical aspect.
An absolute return alternative
While ‘traditional’ mutual fund absolute return fund managers are busy employing long/short strategies to produce non-directional market returns, hedge funds and traders have long been using simple options strategies to generate consistent returns, regardless of whether the market goes up or down.
This options strategy – commonly known as a ‘straddle’ – basically involves buying a call option and a put option with the same strike price and maturity. If the market rises, the call option generates a positive return, and the put expires worthless (without value). If the market falls, the put option generates a positive return, and the call expires worthless.
Buying two options in this manner can be expensive – so traders will often cap the maximum return they can make. Because of this cap, in order to maximise potential gains over a period of time, these ‘straddles’ typically have relatively short maturities, often not longer than 12 months. This allows the traders to ‘re-strike’ the strategy frequently, to gain from as much short-term volatility as possible.
The use of ‘straddles’ to generate absolute returns has some clear advantages over long/short positions on selected assets. Significantly, this options strategy generates returns based on a formula – that is contractually defined to deliver returns, as long as the underlying asset has moved. Long/short strategies may achieve more – but success depends on the manager making the right decisions, on everything they do: what they go long on, what they go short on, when they unwind their positions, whether they change jobs, etc. Options remove all of these active fund management risks – which are carried by the counterparty.
Straddle solution
‘Straddles’ have been used by institutional fund managers, pension funds, hedge funds, traders and sophisticated individual investors – but have not, until recently, been available to retail investors, who have been unable to take advantage of such strategies. The solution for the retail market is packaging ‘straddles’ in a structured investment.
Clearly absolute return funds intuitively appeal to investors, as ideal potential core holdings, and structured alternatives provide a groundbreaking alternative – or complement – for those investors who want a transparent and formula driven approach, with returns based purely on index movement, rather than a fund manager’s skills.
And do not forget those fees – some plans deliver defined risk and returns after any charges – as opposed to mutual fund absolute return fees – that would make even a hedge fund manager blush.
James Chu, managing director and chief investment officer, Blue Sky Asset Management
