Absolute return funds once again fail to hit the target

Markets over the past year have been ideal for absolute return funds to show their defensive mettle, but many have failed to deliver. Cherry Reynard considers the reasons why.

As interest rates rise and quantitative easing is withdrawn, stock and bond markets look set to lose an important support mechanism. Share prices may make further progress, but they are swimming against the tide. In this environment, fund investors may well be looking for an alternative to equity and bond funds, such as targeted absolute return funds.

Over the past year the UK stockmarket has been flat overall, albeit with plenty of movement along the way. These market conditions should have been ideal for absolute return funds to show their mettle and deliver on their target of providing positive returns in all market conditions. For investors, achieving that target would make absolute return funds ideal options in an environment where stock and bond markets struggle. The problem is, they haven't delivered. In aggregate, funds in the targeted absolute return sector have lost money over the past year.

This could be put down to a blip; however, the losses cap a lengthy run of unexciting performance for the sector. The average fund is up just 4.4% over three years and 11.9 over five years. Investors would have done better in higher-paying savings accounts. Over the same period, the average global fund is up 59.1%.

However, arguably this is an unfair comparison. Absolute return funds are not designed to match stockmarket performance, and a double bull market in bonds and equities has made their performance look weak. A recent report by research group Square Mile on the sector points out that absolute return funds have never been tested in a genuine bear market.

Early days

The sector is relatively new. It only launched in 2008, and less than half of the funds in it today existed at the start of 2011, the most recent calendar year in which equity markets showed a loss. The most recent prolonged bear market was during the global financial crisis, when just a handful of funds were on offer. While markets have been volatile and unpredictable this year, that environment doesn't constitute a bear market. For the absolute return sector, the past year just hasn't been its moment.

This makes it difficult for investors to judge the success of funds in the sector. Charles Hovenden, portfolio manager at Square Mile, says investors need to look at the performance of these funds during "down" months in the stockmarket, but there are few data points.

He says:

"Quantitative easing has been in place since March 2009. In this climate, it has been hard not to make money. There have been three minor corrections, but it's still a long way from 2008."

At the same time, talking about the absolute return sector as a whole is difficult. The top fund is up 87.5% over three years and the bottom fund is down 24.9. The sector is multifaceted. Gary Potter, co-head of multi-manager solutions at BMO Global Asset Management, says fund managers in the absolute return sector take vastly different approaches to achieving their targets.

He adds:

"Some funds are basically long-only funds, and as the bull market has run they have done very well. Then there are equity absolute return funds that are market-neutral. They will have a net long position of 0-20%, in contrast to the long-only funds, which may have a 70% net exposure to the market."

Be selective

Potter likes funds such as the GLG UK Absolute Value, Old Mutual Global Equity Absolute Return and the Majedie Tortoise funds.

He says:

"These funds are doing something genuinely different and the good ones have worked well. But you need to do your research and sort the wheat from the chaff".

This can be seen in the respective performance arcs of funds. The City Financial Absolute Equity fund, for example, which is down 26.5% in the year to date, was up 17.4% in 2017, down 10.7 in 2016 and up 22.7 in 2015. This performance contrasts with more consistent returns from the Artemis US Absolute Return fund, which is up 1.8% in the year to date, was up 3.4% in 2017, down 0.9 in 2016 and up 7.7 in 2015. Investors need to decide on the type of experience they want from an absolute return fund.

There are also absolute return bond funds in the sector. These have been in greater demand, as the bond market has seemed to offer little upside. Some investors might question investing in bonds in the current investment climate. However, others have concluded that bond exposure still has a place, but they want a manager with the flexibility to go short on certain parts of the bond market.

Then there are multi-asset or global macro funds. These include a behemoth: the Standard Life Investments Global Absolute Return Strategies fund, now valued at more than £17 billion. The fortunes of Standard Life GARS have informed many investors' perceptions of the sector. The fund's recent weak performance and the complexity of its underlying strategy have attracted much criticism.

Standard Life GARS has perhaps suffered from "tallest poppy" syndrome: other firms have poached senior team members and performance has been closely scrutinised. That said, recent performance has been patently weak and lagged the sector: the fund is down 4.7% over three years and up just 7.4 over five.

Investors have correctly concluded that the sector is a mixed bag at best. Fund selection is difficult because funds have very different approaches and some funds are manifestly weak. However, that doesn't mean no funds merit a place in a portfolio or could prove protective in weaker market conditions. Investors just need to choose carefully.

In general, says Hovenden, if investors want a fund to protect them against equity markets falling, they need an equity market-neutral fund. Multi-asset funds take lots of directional exposure in different asset classes. They may do well in a slower market, but they may not.

Equity market-neutral funds, in contrast, deliberately strip out market performance and aim to add value through stockpicking.

It's important for investors to remember the reasoning for buying such funds, says John Husselbee, head of multi-asset at Liontrust. He explains:

"When people need to apply the most risk, they tend to do exactly the opposite. When they are 30-40% down on their equity funds, they switch into an absolute return product. Many absolute return funds have done their job, but people have often forgotten why they bought them in the first place."

Choose carefully

In choosing a targeted absolute return fund, the important metrics to consider include alpha (the value added by stockpicking), maximum drawdown (the most a fund has lost in a month) and market correlation.

If investors are looking for a fund that behaves differently from the wider equity market, they need one with a low beta score. If they want a more consistent return than they receive from their stockmarket portfolios, they should look for funds with low volatility.

A big moment might be coming for absolute return funds, or it might not. It's difficult to say because they have never really been tested in a bear market. Bear or no bear, the right absolute return fund may have a place in a portfolio as a ballast in difficult times, but the sector needs careful navigation.

Past performance is not a guide to future performance

Fund profile: Jupiter Absolute Return

Part of the problem with the absolute return sector has been that fund managers have handed funds to their best long-only managers, overlooking the different set of skills required for shorting.

James Clunie, manager of the Jupiter Absolute Return fund, is clear about the distinction. For the "long" part of his portfolio, he is an investor, buying and holding sensible companies, collecting a dividend and waiting patiently for the share price to rise. However, in the "short" part, he is more of a trader. Short positions theoretically have unlimited losses because share prices can keep rising. Careful management is required, by putting stop losses in place and checking positions, for example.

Nevertheless, he believes this is where his team has an edge.

He says:

"With shorting, it is important to wait before taking a position, and then accept your mistakes and take losses where necessary. That's difficult. We have worked hard to become good at it."

The fund has no automatic bias, but it has been run with a short bias for the past few years. Clunie says this is because there are many overvalued or problem stocks in the market, including stocks in food and technology companies. On the long side, he has favoured unglamorous areas such as shipping and mining.

For Clunie, the important metrics in judging an absolute return fund are maximum drawdown (its maximum loss from peak to trough) and alpha. He believes investors also need to look at how a fund blends with the other funds in their portfolios and consider whether it is doing something different.

He says:

"We take calculated risks, and if you do that, you can lose money. But, importantly, we only do this to make money. We try to ensure losses are temporary and modest so that investors achieve their long-term goals."

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