Cherry Reynard looks at what the future holds for absolute return funds.
The timing of absolute return funds has been serendipitous. They arrived just as investors were battered by years of volatile equity markets and overall returns had been weak. Many investors were prioritising capital protection over growth, having seen their portfolios slide. But good timing is not the only reason behind their popularity. Most attempts to offer investors a smooth, year in, year out return have seen limited success, including with-profits, fund of hedge funds and, most notoriously, split capital trusts. Absolute return funds, in contrast, have done what they said they would do, delivering positive returns in all market conditions. Will the future for the sector be as rosy?
The sector has grown and diversified since the first fixed income-based funds were launched in 2004. From there, it has more recently branched out into equity long/short and multi-asset funds. Now the sector is increasingly moving beyond the UK and has seen the launch of European long/short funds from HSBC, Ignis Argonaut and Gartmore. Gartmore has also introduced a Japan long/short fund and Threadneedle is poised to launch two US funds into the UK retail market.
The absolute return message has found resonance with investors. In January, the absolute return sector saw net sales of £399.5m, third only to corporate bonds and property. Partly this is because they offer the seductive prospect of positive returns in all market conditions at a time when markets have been uniquely unpredictable, but also because, for the most part, they have performed well as long-only strategies have floundered.
Long-term trends
As the sector is relatively new, long-term performance trends are difficult to discern, but shorter-term trends have been favourable. Overall, the sector has delivered an average fund performance of 13.8% over three years (source: Trustnet to 23 March). This compares favourably to a fall of 8.2% in the UK All Companies sector, and rises of just 0.8% in the Cautious Managed sector and 5.1% in the Sterling Corporate bond sector.
Within that, there has been the greatest variance in equity-based funds. Over one year, returns for these funds have varied between -4.8% and +30.3%. The fixed income funds have shown less variance, with one year returns falling between -0.7% and 9.6%. The multi-asset funds have returns varying from 5.1% to 25.9%.
So far, so good, but can the sector maintain momentum? These funds can look appealing in a bear market when long-only funds are falling 20-30%, but less so in a strong bull market, when their performance may be significantly below that of their long-only equivalents. To date, the sector has maintained its popularity, in spite of the average one-year performance being 37.7% behind the UK All Companies sector. Most absolute return managers have made it clear that returns would not keep pace with soar-away equity markets and 2009 was undoubtedly an unusual year, but investors may lose their enthusiasm if equity markets keep rising.
For the time being, it is difficult to discern any trends from the IMA statistics. There was a slowdown in sales from December, when absolute return funds were the best selling sector, to January when they had slipped to third. But it is a ‘hot’ sector with a lot of launches at the moment, which may skew fund flows into the sector from month to month. Market volatility is likely to be too fresh in investors’ minds for them to have been turned off the absolute return concept yet. Equally, with the outlook still uncertain, faith in traditional equity funds is still shaky.
Charles Robinson, head of alternatives distribution at HSBC, says: “While you are never going to get the timing right, the backdrop is good at the moment – equity markets have been choppy, bonds are not compelling value and there remains a good case for a strong skill-based manager.”
Richard Pursglove, head of UK retail at Gartmore, says the funds are broadening out to a wider investor base: “This type of fund tended to be for high net worth investors. Now it is a diverse range of clients, incorporating individual financial advisers, multi-managers and private banks.” He believes that after a strong rally in asset prices, including equities and corporate bonds, investors are revisiting their asset allocation and choosing to play safe.
Can absolute return funds go one step further and become the core rather than a satellite product in investors’ portfolios? Simon Mungell, head of multi-manager at Ignis, says: “Traditional fund managers have adopted techniques previously unique to hedge funds, and hedge funds have moved more into the realm of the retail investor.”
He believes rather than absolute return investing being a new asset class, it is just a style of running money: “There shouldn’t be an exposure to the UK, US and then absolute return. It is appropriate in every market. It is perfectly natural to have part of a fund’s US/Europe exposure run in this way, particularly if market returns are uninspiring. The new launches are part of a maturing of the market – people are realising it makes sense to run money in this way.”
Blurring the boundaries
Robinson suggests while it is increasingly clear the new Ucits III launches are blurring the lines between the long-only and long-short worlds, investors are still using absolute return funds in a variety of ways. Many investors will still put absolute return funds in an ‘alternatives’ pot alongside a standard portfolio of global, long-only equities rather than simply having an absolute return funds as part of a wider Japan exposure, for example. He believes this may change as investors become more comfortable with the absolute return concept.
This will be helped along by the increasing diversity in the sector, which is seeing a wealth of new launches. Over the past year, there have been isolated launches in the fixed income sector – for example Threadneedle soft-launched its Credit Opportunities fund in September 2009 – but the main thrust of the launches has either been in UK equity long/short funds or in non-UK long/short funds.
To date, the majority of new launches have been built from existing funds, or existing processes. Usually managers have been running offshore funds. Gary Collins, head of wholesale distribution at Threadneedle, says the team that would run the new Threadneedle US long/short funds (which are still waiting for FSA-approval) have already run an offshore product along similar lines and a 130/30 fund. Most absolute returns funds already have an indicative track record. The HSBC European Absolute fund, for example, had been running offshore for two years before its launch.
Is there room for more than one absolute return fund in a portfolio? Mungell is in favour of diversifying any absolute return holdings within a portfolio because of higher manager risk: “Fund managers have more scope for getting things wrong in absolute return. We need to ensure managers are aware of the risk they are taking and they are adding value for it.”
Collins says often absolute return funds will be aiming to do different things: “For example, in our Absolute Return Bond fund, we run to a value-at-risk of one. This means we have a maximum tracking error of 4.32% over cash. Equity absolute return funds may have three or four times that. Clients may have a drawdown of up to 5% in one month. Most equity funds will be aiming for an annual return of 8%-10%. With our funds, when Libor is less than 1%, investors aren’t going to see big returns. When Libor was at 6%, we returned up to 12.5%, but that won’t happen year after year.”
Collins gives the example of the kind of differences that can exist between fixed income funds: “Our Absolute Return is a macro fund taking views on issues such as interest rates and currency. Our Credit Opportunities fund looks to add value in credit markets – high yield, emerging markets and investment grade. Both have got absolute return benchmarks, but are quite different in approach.”
Equally, the equity funds will vary in how they achieve their returns. David Griffiths, investment manager at Aegon Asset Management says the group’s new UK Equity absolute return fund aims to have little net exposure and run with a beta of near zero. It will use pair trades, themes and best ideas to deliver performance. Compare that to, for example, the Gartmore UK Absolute return fund, which will be up to 70% net long or 50% net short of the market and aims to generate two-thirds of its returns through short-term trading strategies. Both may be equally effective, but the approaches are different.
Pursglove believes more esoteric strategies may come to the market over the next five years. This has concerned some investors who believe offshore hedge funds are trying to shoe-horn themselves into a Ucits III structure in order to reach a wider investment audience. The structure has certain protections, including liquidity constraints, which makes it difficult to put, for example, distressed strategies in this structure. That said, it remains a risk to the reputation of the sector and Robinson says there should be a clear distinction between a Ucits strategy and offshore unregulated hedge funds.
Increasing diversity
This increasing diversity is likely to create some issues for the IMA in the future. Pursglove compares the absolute return sector to the corporate bond sector 10 years ago: “Then, investors could not buy a corporate bond fund. The credit market was embryonic and then gilt funds starting mixing in corporate bonds, then corporate bond funds launched in their own right and then high yield. There are currently around 30 funds in the absolute return sector and as the numbers increase, further consideration should be given to breaking up the sector.”
Griffiths says: “There is a very wide spread of risk and return and people may be trying to add alpha through global macro strategies or equity long/short strategies. We may be competing against people who are aiming to deliver 25% annual volatility and we work to much less than that. It is a very diverse category and there is already talk about dividing it up.”
There are threats to the sector. If the history of fund management is any guide, the popularity of absolute return funds will almost certainly lead to a spate of ‘me-too’ launches. Although existing absolute return funds have tended to be built on existing offshore funds and launched by experienced teams, long-only managers with little experience of shorting may try their hand. As absolute return strategies are dependent on fund manager skill, investors may be disappointed. Equally, many of the funds have a performance fee, which may eat into returns.
Pursglove concludes: “There has been a broader understanding of what absolute return funds can do as part of a portfolio in terms of diversification and low correlation to the equity market. It is important to remember that many of these strategies have been running for a very long time.” While the sector continues to deliver consistent returns, it will look attractive compared to long-only markets. It may also form a larger part of investors’ portfolio as the sector grows and diversifies. However, its popularity is also a threat – attracting more esoteric strategies and less experienced managers, which may ultimately harm its reputation.
