Do absolute return funds have a future?
Asset allocation conundrums have traditionally revolved around striking a balance between bond and equity exposures, premised on a view around the direction of the economic and market cycle at any given time.
That is based on the premise that bonds and equities move in a way that is inversely correlated, that is, move in opposite directions. If market conditions are benign, equity valuations would be expected to move upwards, and bond prices downwards, and when markets are turbulent, bond prices rise, and equities fall.
The persistent rise in bond prices that can be traced back 40 years to the start of the 1980s when central banks began to, finally, tame the very high inflation that became endemic in the 1970s, and continued until 2021, caused many market participants to ponder if more ingredients were needed in a portfolio to ensure diversification.
This caused businesses to launch products that had the aim of “delivering positive returns in all market conditions” by investing in a very broad range of assets and asset classes, and effectively replace some of the bond exposure in portfolios.
Among the very first such products to launch into the UK market was Standard Life, which came to market in 2013, and at one time had assets under management of more than £20bn, though the latest data from FE Analytics now places the AUM of the fund at £2.3bn, indicating AUM dropped by close to 90 per cent in four years.
The performance of the fund has been quite weak, losing money over the past year, and even on a five-year basis the fund has returned just 3 per cent, during a period of a rousing bull market. It lost money in two of the calendar years between 2018 and 2021. It suffered net outflows of more than £700m in 2021.
Over the past five years, the Investment Association Total Return sector has returned 8 per cent.
The sector as a whole had outflows of £3bn during the year.
A familiar refrain from advocates for the sector is that the generally benign conditions in financial markets in the decade after the financial crisis meant that volatility was low, and such funds are designed for a climate when turbulence is high.
Bertie Dannatt, who runs an absolute return strategy at Ruffer, compares markets in the decade after the financial crisis to "water running up a beach. There was so much liquidity from central banks in that time that all asset prices, bonds and equities rose. All you can do in that sort of market is be prepared ahead of time for the risks that are out there".
He adds: "We don’t believe it is possible to time markets, but one can have certain investments that can offer protection against the risks that are there, and we felt for a long time that the major risk was inflation, and we feel that now as well. But for the decade or so when it didn’t happen, we had those hedges in place, including owning gold. What has changed is that in the past, that ballast in portfolios came from bonds, which provided an income, but that is not the case anymore.”
He says the present market conditions mean the equity investments in his fund have been falling in value, the hedges in the portfolio have performed well, and this is how absolute return type strategies are supposed to work.
With volatility gripping the market now, absolute return fund managers may find market conditions more to their liking.
Barry Norris, who runs a fund that sits within the absolute return sector at Argonaut Capital, says this argument has some validity, but the problem is deeper.
He says most of the original absolute return funds “were run with the principle of having low volatility, and that is fine, but the problem is they also had low returns, and people invest to generate a return, and if you have a low return, low volatility product, you are essentially asking clients to pay an active management fee to get the same return as from cash”.
Tom Boyle, a fund manager on the Atlantic House Total Return fund, says: “Historically many absolute returns funds haven’t taken a great deal of risk in the belief that they were protecting investors' capital. In reality, most had taken just enough risk to impact the funds in a period of high stress. If you took the analogy of a bond, those absolute return strategies could be likened to short-duration investment-grade bonds. Not a great deal of upside, but at the same time, ultimately correlated to equity when the really bad times come.”
One of the founders of the original Global Absolute Return Strategy fund, Euan Munro, later defected to set up a similar mandate at Aviva Investors and subsequently became chief executive at that business. Other members of the founding Gars team joined Invesco and launched an absolute return fund, and those three remain the cornerstone products of the industry.
Peter Fitzgerald, who is now the lead fund manager on the £2.5bn Aviva Investors Multi-Strategy fund, the company’s absolute return product, acknowledges that many in the sector have been too focused on volatility management, saying: “There has not been enough risk taken to achieve the return target, but they hit the volatility target.”
His mandate hit the targets it set itself over the past three years, but not over the past five years. Of this he says: “We have not done a good job on a five-year view. I think it is a bit of a cop-out to say that market conditions have been benign and so not sympathetic for absolute return funds. Clients want returns, but they want returns that are not correlated with equity markets. People have become obsessed with volatility management.”
One of the ways he says funds in this sector can achieve a positive return is to always have exposure to equities, alongside any of the more esoteric assets that are owned in order to manage volatility.
Fitzgerald says: “One of the mistakes I think [that] has been made in the sector in recent years is that, if a manager doesn’t hit their return targets they decide the right thing to do is to take less risk, as they become determined to not lose money, but that caution means they also don’t make a return.”
He says the role absolute return funds should have in the market is to act as a way for clients to gain access to hedge fund type strategies.
"I think it is a bit of a cop-out to say that market conditions have been benign and so not sympathetic for absolute return funds." Fitzgerald, Aviva Investors
Traditional hedge funds often have a minimum investment limit which would be out of the reach of an advised client, but also invest in less liquid assets, and so are not suitable to offer daily dealing, which tends to be a requirement for the typical advised client.
Fitzgerald says: “Of course we put some hedges [against risk] in the fund, but you can’t hedge against every risk, or you won’t make money.”
An example of the decline in client interest in absolute return strategies is that Fitzgerald and his team once managed just under £10bn across their various products, a total that has shrunk by 50 per cent.
Charles Hovenden comes from a hedge fund background, but is very sceptical about the value of absolute return funds in portfolios.
The senior investment manager at Square Mile says the founding principle of the sector is "that it can deliver positive returns in all market conditions. That is impossible in the real world".
"In the first quarter of 2020, when volatility was very high, one of the best known funds in the sector lost 20 per cent. The thing is, that fund was very net long in terms of its equity exposure, and I would ask, if you are that significantly exposed to equity market risk, how can it be an absolute return strategy, which aims to deliver a return in all market conditions, be in a position where a drop in equity markets means the fund loses money?"
He says this is the fundamental contradiction at the heart of traditional absolute return strategies: if they do not have significant equity exposure, then it is hard to achieve attractive returns, even if the volatility is high, while if you have little exposure to equities, you get low volatility but low returns.
"Historically many absolute returns funds haven't taken a great deal of risk in the belief that they were protecting investor's capital." Boyle, Atlantic House
Hovenden’s solution is to recommend for clients only those funds within the sector that also engage in the short-selling of equities, as this enables one to profit directly from the fall in equity markets as well potentially the rise, allowing for equity exposure that can also have lower volatility.
Argonaut's Norris does engage in short-selling in his fund. He says: “Short-sellers get a bad rap. This is partly because the things we short sell are in areas where there is a dominant narrative. One example of this right now might be renewable energy. We think there could be profits to be made from short-selling renewable energy companies for the next decade. But it is not something people want to hear, and we are aware it doesn’t always work."
He adds he would always have a “net long” position in the portfolios, meaning he will always have more equity investments that are profitable if they rise in value than if they fall in value.
Fitzgerald also engages in short-selling in his funds, but says the major change in markets now is likely to be that the characteristics of a company, such as whether it is profitable or not, have become more important than the geographical location or the sectors in which it operates.
By David Thorpe, special projects editor at FTAdviser
This article can also be read here: FTAdviser