The absolute return sector has proved popular with investors yet confusion remains over the scope, target returns and investment time horizon of absolute return strategies
Compared to relative strategies, where returns and success are measured by the performance of the fund versus a benchmark, absolute return strategies should firstly be judged by the sign in front of the fund performance statistics (+/-), and secondly by their ability to achieve a pre-defined target return.
A few examples of descriptions from marketing materials illustrate the wide range of interpretations circulating in the market:
1. Absolute return strategies aim to deliver a specified target return above the risk-free rate, while protecting against capital losses in any short sub-period.
2. Absolute return strategies aim to deliver a specified target return above the risk-free rate, while protecting against capital losses over the short to medium term.
3. Target returns above risk-free rate are to be achieved in the long term. Short- to medium-term negative returns can occur.
Objectives
Although definition one sounds like paradise for a client, it is pretty obvious that in order for the investment manager to achieve a return that exceeds the risk-free rate, there will be an element of risk involved and therefore short-term negative returns may occur. In other words, too much focus on avoiding short-term losses would prevent the manager from achieving his medium- to long-term objectives.
The approach in definition three gives the manager more chance of achieving his target return, but it ignores clients’ requirements for capital preservation. This description could even be used to describe a traditional approach.
Definition two is more sensible, covering the objective of achieving capital preservation in the short to medium term, while giving the manager scope to take the risks required to deliver additional returns.
The combination of short- to medium-term capital preservation and returns above the risk-free rate is not simply ‘delivered’ by the market. The traditional approach is either to pursue capital preservation and no excess return, or higher returns at the expense of short-term capital preservation. The combination of the two is something that needs to be created by the investment manager. Various approaches are used to achieve this combination, some more successfully than others.
Understanding the investment approach
It is difficult to judge the potential and sustainability of the various absolute return approaches and products. Investors must identify what the objective of the strategy/product, and what the strategy can reasonably deliver in different market environments, especially times of high stress when capital preservation is most needed.
Even if an absolute return product has historically delivered attractive returns, investors must consider the market circumstances in which these returns were delivered. They should be wary of a broadly diversified portfolio with a risk/return profile optimised on factors such as historical returns, historical volatility and diversification. The desired levels of return and risk can only be achieved if the historical data also applies to the future and the market is fairly valued. However, those two assumptions are unrealistic as markets are rarely in equilibrium.
Approaches
A common approach used in the management of absolute return products is to invest in asset classes that have historically shown low levels of volatility, while delivering an attractive return compared to its volatility (i.e. a high sharpe ratio). This entails some major risks. Although history suggests large moves are unlikely, when they happen it can have a huge impact if you are not prepared. The problem is compounded by the use of leverage, which is frequently employed with this approach to amplify returns. The low volatility levels of these asset classes lead the investor to mistakenly believe their risk is low, and does not recognise the magnitude of potential losses should “highly improbable” events materialise.
Absolute return managers should account for:
A. Anomalies and extreme events occurring more frequently, giving rise to opportunities to generate extra performance.
B. The varying risk factors for each asset class. In order to keep the overall directional risk low, a manager must consider quality, not quantity, of diversification. Diversification does not mean making 100 bets driven by the same risk factors.
Sounds good in theory – but in practice?
We believe an absolute return strategy should seek to generate a target return above the risk-free rate, while protecting against capital losses in the short to medium term. Strategies that promise to achieve returns above the risk-free rate, while guaranteeing capital protection over the short term cannot work. Strategies that only aim to avoid capital losses in the long run are simply traditional, relative approaches with a different name.
Once the approach has been identified, how should it be implemented to deliver the promised results?
Multi-strategy
A multi-strategy approach, which combines different sources of performance generation, driven by different risk factors, results in a portfolio with low directional risk. Performance opportunities should be identified through a consistent focus on fundamentals and valuation. Optimisation strategies and shortfall analysis based on historical risk and return measures are based on unrealistic hypothesis and cannot deliver absolute returns on a sustainable basis. A multi-strategy approach can adapt to the different market conditions. Market conditions and opportunities change over time, and managers must have the flexibility to increase risk when the market compensates generously for it, and reduce it when valuations are stretched and the market does not offer adequate compensation for the risk you are taking.
A successful absolute return strategy requires alpha generation, portfolio construction and risk management. A balanced combination between quantitative risk measurements, a stop-loss approach and common sense creates a robust risk management framework. Quantitative measures like VAR and standard deviation are useful but must be used in a pragmatic way: blindly relying on such measures can be dangerous, as they are calculated based on assumptions that usually do not hold up in periods of high market stress.
Enzo Puntillo, manager, Julius Baer Absolute Return Emerging Market Bond fund
