Net sales for IMA Absolute Return sector have reached a total of £2.55bn since its launch in April 2008
Demand for absolute return funds increased significantly in 2009 with the sector becoming second-best net selling in the IMA last year.
Net retail sales for the IMA Absolute Return sector totalled £2.55bn, despite the sector only being launched in April 2008.
Avoid comparisons
The IMA warns comparisons between funds should be avoided because of the diverse nature of the vehicles populating the sector, including different benchmarks, risk characteristics and timeframe for delivering performance.
Of the 29 funds with more than a one-year track record, 26 can claim a positive total return over the 12 months to 12 February, with an average return of 10.4%, according to Morningstar.
However, there is a wide differential between the best and worst performers with the largest faller dropping 2.6% over the period.
By contrast the top performer in the sector – the Octopus Absolute Return fund – has returned 34.1% over the past 12 months.
The long/short Octopus fund, which targets returns of 10%-15%, aims to produce high absolute returns by looking for miss-priced stocks.
“One of the reasons the fund has produced above-normal returns is because the market has been more volatile than expected, and if you get it right in a volatile market you make better returns,” manager David Crawford says.
By contrast, Crawford says, during a period of lower volatility the fund is more likely to make lower levels of returns.
In December, the fund was down 0.3%, which Crawford admits is “a disappointing performance considering our net long position.”
He says: “Financials and domestic cyclical stocks continued their underperformance and we also had some short positions in the large mining stocks that affected performance.”
The manager added to his position in Lloyds Banking Group, following its rights issue, and took a new position in ING Group, following a period of underperformance.
“Both these positions have worked well since the end of December,” Crawford says.
He also did some restructuring during December, cutting some positions and adding to other names where he had confidence in their potential.
Crawford says: “We are focusing on the long book of smaller companies, so that we are in the right stocks for 2010. This year is unlikely to be as exciting as 2009 – good news for many.
“It feels like the start of 2010 could be better than later in the year. Eventually, global monetary tightening and earnings momentum peaking will create a headwind for equity markets.”
The 2009 rally
He believes the extent of the 2009 rally meant a lot of future performance for cyclical stocks, which normally comes through gradually, got pulled forward, leaving stocks less attractively priced and more vulnerable to changes in sentiment.
“With this in mind, we are running the fund with a high gross exposure – approximately 190% – but a lower net long exposure,” Crawford says.
“The higher gross is required as lower volatility means position sizes need to be larger
to generate reasonable returns. The lower net long position is due to an increasing ability to find short ideas and a greater desire to reduce market exposure.”
BlackRock were among the first to introduce absolute return funds to the retail market with the launch of Mark Lyttleton’s BlackRock UK Absolute Alpha fund in March 2006.
On a three-year view the £1.8bn vehicle is up 17.4%. Over the last year the fund gained 7.5%.
The manager admits the fund had a difficult period in December, registering a modest decline while the FTSE All-Share index rose 5.5%.
Frustrating returns
He says: “The return was frustrating given our positive view on markets, but while the fund did not perform as we expected we are optimistic about the future and excited about the potential returns possible of a number of our positions in the coming months.
“Our long book performed credibly, but both our relative and short strategies detracted from performance.”
Lyttleton notes equity markets were buoyed in December by further signs of improving economic conditions and corporate results that continued to exceed expectations.
Enthusiasm
He says: “We are very enthusiastic on the beneficiaries of recovering corporate discretionary expenditure from depressed levels, given balance sheet strength and improving confidence among executives.
“We have a number of positions across the leisure, media and technology sectors that reflect this theme.”
He remains positive on the banking sector as financial markets continue to heal.
“Given its sheer size Lloyds’ capital raising was understandably troublesome for the market in the near-term, but trading conditions have improved dramatically for domestic retail banks,” Lyttleton says.
“Asset spreads are elevated, funding costs have fallen and the outlook for provisions is considerably better. The spectre of increased regulation is troublesome but all bar the very worst outcomes appear to be discounted in modest valuations.”
Lyttleton says his short book performed poorly, predominately because of his positions in the general retail sector, which benefited from upgrades over the fourth quarter.
He says: “We are sanguine on the outlook for global growth, we are more cautious in our view on the domestic economy in the context of stretched valuations.
“While consumer spending has held up better than we might have forecast, debt levels remain very high relative to history and improvements in disposable income driven by reductions in VAT and mortgage servicing costs will reverse next year.
Perilous state
“Government finances are in a perilous state and the need to reduce public expenditure and raise taxation will further impact growth and employment. We have retained our negative view.”
He attributes what he calls “the disappointing performance of our pairs” to three strategies:
“Within real estate we have held a cautious view on commercial assets and are more positive on residential property. This did not work over the period, while positions in the leisure and consumer staples sectors also detracted.”
Threadneedle’s £522m Absolute Return is one of the few funds in the sector with a track record of more than three years.
Launched in October 2005, the vehicle is up 22.9% over three years, and up 2.8% over the last year.
Co-managers Peter Allwright and Quentin Fitzsimmons aim to achieve a total positive return in all market conditions through exposure to global bond markets.
The fund invests primarily in derivatives, cash, fixed-interest securities, index-linked securities, money market instruments and deposits.
At times the portfolio may be concentrated in any one or a combination of such assets. The managers can take long and short positions through derivatives.
Difficult December
Fitzsimmons notes government bonds had a difficult month in December as governments sought to sell large numbers of bonds to fund ballooning levels of debt. Demand was also undermined by growing concerns over future inflation and investors’ preference for rallying equity markets.
European government bonds came under additional pressure over worries about the Greek government’s perilous debt overhang and the potential for these difficulties to spread to other peripheral Euro zone markets.
Fitzsimmons says: “The portfolio posted a small negative return for December, as gains from the derivatives overlay and foreign exchange (FX) trades were offset by poor performance from the short-dated bond portfolio, as short-term yields increased.
“In FX, the fund held a long position in the US dollar versus the euro, and this trade performed well.”
Meanwhile, positions to take advantage of rising bond yields in the US and UK added to
performance in the second half of the month, although a long position in UK gilts versus German bunds at the start of the month detracted.
Options strategies on UK interest rate futures expired, and the resulting cash added to performance.
