Over the last few months I have been spending a fair bit of time talking absolute returns with some of the best fund managers in the business.
My motive for talking to the likes of Mark Lyttleton at BlackRock and Tim Russell at Cazenove was to probe a number of key themes that have been bugging me for a while, namely what constitutes an absolute returns mandate and how does the manager accomplish it in practice?
There is a lot of waffle out there about cash-plus returns and long/short trades but this is all just marketing juju magic for me – for a start all good fund managers should be thinking about cash plus returns otherwise why would I choose to take my money out of cash and stick it in shares (unless of course we have all turned into market timers playing the stock market cycle, perish the thought)?
Also many contrarian managers have been practising long/short disciplines for a long time, especially in the hedge space where value boys are two a penny. So, let us dump the marketing lingo and concentrate on finding out what it is that actually goes on inside the engine room – what is the mechanic that drives returns?
In this first wave of interviews I spoke to four managers, all of whom have very different processes: Martin Gray at Midas/Miton is effectively a multi-market asset allocator; Jonathan Ruffer at Ruffer LLP marries top-down thinking focused on big macro trends with a bottom up value-based stockpicking approach; Lyttleton operates a sophisticated pairs trade in the stock-specific UK equity income space while Russell at Cazenove also works in the UK equity space, basing his success on a switch mechanism between cyclical stocks (in booming markets) and defensive, quality stocks in slowing or retreating markets.
Each of these managers is radically different in their approach yet I fear more than a few advisers and many an investor has no real idea of the style biases and risks of each approach.
I have no doubt the big wealth houses with their legions of researchers can make this call – and carry out the specific level of detailed strategy research – but I am rather less confident with most mainstream advisers.
I am also not sure advisers and investors understand how to use these strategies within a diversified portfolio – I have heard of more than a few investors being told the big switch for the main part of their portfolio should be away from corporate bonds into absolute returns with a UK bias. I have my own, private doubts about the validity of absolute returns as an investment class – words like marketing hype and outrageous fees spring to mind – but I accept that for the 10%-50% of a portfolio that is allocated to UK equities, absolute returns managers like Lyttleton and Russell can work wonders, some, though not all, of the time.
Which is where managers like Ruffer and Gray come into the mix. They have no worry about making big calls on everything from emerging markets stocks through to currency trades – they are proper asset allocators. The portfolio construction process that connects the big thought with the actual investment mechanic is again very different – Gray uses many closed-end funds and is willing to use ETFs where appropriate whereas Ruffer uses a bottom-up stockpicking approach which basically says to the (in-house) analyst “buy me the best share to make money from this trend... at the best price”.
The latter approach arguably increases the risk of poor stock selection while the former invites the curse of momentum seeking as the top-down asset allocator discovers his underlying fund managers have all piled into the same funds. Crucially, both need to be willing to go long cash.
I would be happy to put a large part of my diversified portfolio into this type of fund because the intra-fund diversification is great and the risk control mechanisms explicit (in both cases the managers attempt to mitigate risk by buying undervalued assets with a margin of safety). But I would only do that precisely because I know these managers are willing to have as much as 50% of their assets in cash as they await the right buying opportunity. According to both managers, this apparently presents a ‘real problem’ for many advisers who reckon that the market timing decision is ‘theirs’... an admission that fills me with considerable fear as academic study after academic study has suggested market timing, even on the most strategic of bases, regularly destroys investors’ wealth.
David Stevenson is a Financial Times columnist and consultant. Email him at davidcstevenson@gmail.com
