Absolute return funds: Why they rightly have a bad reputation

Promising to protect capital but failing to deliver, these funds have a poor reputation, and rightly so.

The most unloved bull market in history continues to rumble on: 2019 (to the end of October) has proved a good year so far for investors, with gains to be had in both developed and emerging stock markets.

But despite markets marching on after recouping losses sustained during the final quarter of 2018, the mood has been one of general caution – and that was before the announcement of a UK general election to take place on 12 December added to the lengthy list of uncertainties that could stoke a rise in volatility and blow global markets off course.

Diversification is key

Against this backdrop, as Victoria Hasler, head of research at fund analytics firm Square Mile notes, diversification is key, which involves investors ensuring they have an appropriate mix of defensive and more adventurous investments. And on that front, she adds, there’s a much stronger case to add to more defensively positioned funds. Across various fund sectors, Hasler says:

"Fund managers bought into the downturn (in the fourth quarter of 2018) and then rode the recovery in the first quarter of 2019, but since then their focus has been on reducing risk, with one reason being the increased talk of a global recession."

For similarly minded investors who are feeling more fearful than cheerful, the most obvious starting point when looking for funds with a capital preservation stance is to weigh up the rebadged targeted absolute return fund sector.

Prior to 2013 the funds went under the absolute return moniker, but following an almost two-year review of the sector the word ‘targeted’ was added, to clarify that funds target positive returns in all market conditions but cannot guarantee such returns. Funds in the sector had come under fire for poor performance in not delivering positive returns, which triggered the review from the Investment Association.

At the time, industry commentators were underwhelmed by the name change, and the sector as a whole has struggled to change its spots. Fund performance for the majority of the sector has continued to disappoint, meaning investors should tread very carefully. “It really is important to know what you are buying; or if you own a fund in the sector, ask yourself why you own it,” points out Darius McDermott, managing director of FundCalibre.

He adds:

“At a sector level, targeted absolute return funds have come in for severe criticism, and primarily that’s down to the funds with a more aggressive approach, which are essentially hedge funds. Some of these funds can shoot the lights out in a given year, but they have made big losses as well.”

Funds in the sector have a plethora of tools at their disposal to try and protect investor capital during more turbulent times. These include the ability to go short – betting against the fortunes of a company in order to make money if its share price falls. In addition, currency hedging techniques are often utilised by funds in the sector to protect or make money from currency swings. Other tools used include derivatives, buying futures and writing options.

Losses can be magnified

The trouble with these extra bells and whistles is that when the wrong calls are made, losses are magnified. The final three months of 2018 are an example of this; the period produced the 11th worst quarterly performance for global stocks over the last 48 years, according to data from Refinitiv.

As a result, 2018 as a whole was a tricky year for investors to make money; and to add to the pain, those who put their faith in targeted absolute return funds would probably have been disappointed.

Figures from FE Analytics show that 16 funds in the sector produced a positive return, while the vast majority, 93, were in the red for 2018 as a whole. Unfortunately, this is not a one-off. The last time funds endured a stormy backdrop, following the European Union referendum vote in 2016, 30 of the 93 then in the sector produced negative returns for the year.

“Absolute return funds should be a diversifier in a portfolio, so the performance numbers in 2018 for the sector as a whole are disappointing,” notes Hasler. She adds that “taking on too much risk” is the chief reason for so many funds failing to ride the storm.

“As a whole, the past decade has seen markets go up most of the time, and I think this led absolute return fund managers to take more risk to achieve their objective, which for most is to meet a specific target over a three-year timeframe. Unfortunately, though, the final quarter of 2018 caught many of these funds out.”

In the year to date the sector has fared better, although this is against a backdrop of much less volatility than in 2018. Data from FE Analytics at the end of October shows 102 funds have made a positive return, while 16 are in the red. Top of the tree are Natixis H2O MultiReturns (up 16.4%), Liontrust GF European Strategic Equity (15.6%) and Argonaut Absolute Return (11.9%).

But, as Hasler points out, echoing McDermott’s comments, there’s a tendency for funds to over-deliver through being too aggressive.

“Slow and steady returns are what investors want from funds in the sector. Funds that lose 0.5% or 1% in a given year are not a disaster – in fact I would be more concerned if a fund returned 10% or more over that time period, because what goes up that much can go down that much.”

Two distinct strategies

As a result of the two distinctly different strategies in the sector – the hedge fund-like funds and the less complex, more conservatively minded funds that do not take excessive risks – there have been calls for the Investment Association to split the sector into two.

It goes without saying that such a move would certainly be much more radical than the last time the sector was reviewed, but it is also one that would be welcomed by Money Observer as a means of helping self-directed investors to navigate the sector more smoothly than they can at present.

Splitting the fund sector into two would also help ensure that retail investors do not end up with more than they bargained for by unwittingly selecting a hedge fund-style strategy that is much more suitable for institutional investors.

How to sort the wheat from the chaff

We have discussed above how important it is for investors to identify absolute return funds that place a big emphasis on capital preservation. The first thing to do is look back at how a fund has fared over different timeframes; if a fund has made an excessive return over any one-year period, rule it out.

A less crude approach, in order to measure consistency, is to look at a fund’s maximum drawdown over a certain timeframe. This little-used but very useful metric shows what an investor would have lost had they bought and sold at the worst possible times. The lower the figure, the better. Such data is hard to access or find for free, but Money Observer has crunched the numbers using FE Analytics data, with the 10 funds in the table above having the lowest maximum drawdown score over the past three years to the end of October.

The top scorer under this metric is Kames Absolute Return Bond (which would have lost investors a maximum of 0.8%), followed by Man GLG Alpha Select Alternative (-0.9%) and TwentyFour Absolute Return Credit (-1.5%).

Notes: *Over a three year period to end of October. Source: FE Analytics

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.